Japan – A stir of echoes. Anticipating QQE3 and beyond

Japan’s economy is exhibiting the same critical trends that were seen during its long expansion in the 2000s. The expected consequence is an income-lite growth path that challenges the BOJ achieving its 2% inflation target. More policy stimulus is needed, and QQE3 (and beyond) is likely to be forthcoming. Fears that shortages of JGBs will preclude further stimulus and require a BOJ taper into 2016 are misplaced: there are potentially over JPY200trn of JGBs that the BOJ can buy. More QQE will help restore the trend of a weak-JPY and support the Nikkei while investors should expect fresh record lows in JGB yields. The current move in USD/JPY below 120 is an opportunity to scale into USD-longs while for those that can overcome the ticker-shock of low yields, the “old faithful” point of the JPY interest rate market – the JPY IRS 7fwd 3yr – is looking appealing.


A stir of echoes – Japan’s income-lite recovery in the 2000s and now

Sometimes, history repeats rather than rhymes. A sense of deva vu accompanies a reading of much of the current analysis of Japan’s economy. Hopes remain that a healthy corporate sector that is generating record profitability can be the touchstone for a sustained emergence from a low growth/ deflationary climate. The expectation is of profitability begetting higher capital expenditure and, via the conduit of higher wages, stronger household consumption. Just last month, BOJ Governor Kuroda anticipated a “virtuous cycle of income to expenditure to continue to operate in both the corporate and household sectors”.

Chart 1. SME’s drive Japanese household incomes and are facing a structural break in their formerly symbiotic relationship with large firms


Source: CEIC

The “virtuous cycle” – evidence fails to displace hope

The problem with such sentiment is that we have been here before, and quite recently. Japan’s 2002-2007 economic expansion was replete with references to an “imminent” pick-up in household income and private consumption, with the lift-off phase tending to be merely pushed back in the face of soft incoming data. Despite still low inflation and household consumption, the BOJ even felt able to hike interest rates in July 2006 to general applause from the economic commentariat (and to horror from those who noted the lingering deflationary impulses). The “virtuous cycle” growth path never occurred, which left Japan particularly ill-prepared for the 2008-2009 phase of the Global Financial Crisis.


SMEs drive Japanese wage growth and face a growing headwind

One of the critical factors that restrained private consumption during the 2000s is again present in Japan’s economy, and it’s significance continues to be overlooked. In the 2000s, large Japanese firms became more aggressive profit maximisers amid an increased focus on shareholder value. This altered the symbiotic relationship that had existed for decades between large firms and SMEs. Previously the profit cycles of these two sectors of corporate Japan moved in tandem, with a strong performance at a major firm seeing business flow through to it’s network of SME suppliers.


In the 2000s, however, the profit cycles diverged. Large firms increased profits by squeezing the margins on SMEs. (Chart 1.) This is critical since SMEs dominate much economic life in Japan and employ around 70% of the workforce. SMEs determine wage growth trends in Japan. Despite the talk of labour shortages in Japan – which are more skills mis-matches – SMEs are not positioned to provide sustained wage gains via a higher labour share of profits. (Over the past two tears, profits at large firms have risen to 63.6% of their total personal expenses from 45.6% – a trend naturally exaggerated by the economy’s cyclical upswing – while among the less efficient and far more labour intensive SME sector, profits have also risen to 22.4% of personal expenses from 17.2%.)


The government’s efforts to further increase the focus on shareholder value and to improve corporate governance in Japan will only increase the wedge between large firm and SME profit trends, with adverse implications for household income. In Q2 2015, the large firm/ SME profit gap reached a record 2.2% of GDP. (When have structural reforms not been disinflationary in the short-term…)


Household income remains weak

Given the headwind facing SMEs, it should be little surprise that household income growth remains so weak. Average monthly cash earnings declined -0.4% Y/Y and the 12 month trend is -0.3%. (Chart 2.) Soft consumer demand exaggerated the sensitivity of Japanese output to weaker overseas demand. Without stronger income growth, household consumption will stay soft as Japanese consumers are far from embracing leverage. The cycle of deflation cannot be broken without higher household consumption that is sufficient to spur demand driven price gains. Inflation without this component is merely a squeeze on household disposable incomes. Sure enough, real household income and consumption are both below the levels seen prior to Abenomics.


Chart 2. Japan’s household income growth is expected to continue to disappoint


Source: CEIC


2% inflation will not be met on schedule

In this context, the BOJ’s forecast of 2% inflation in the first half of FY 2016/17 seems highly unattainable, which may be acknowledged when the BOJ reveals it’s revised economic outlook on 30th October. (Core-core CPI, which strips out food and energy price swings, measures just 0.8% Y/Y). More worryingly, as was the case a decade ago, Japan‘s economy looks poorly placed to withstand a shock, whether this is policy driven (the planned consumption tax hike of April 2017) or exogenous (the on-going decline in global and particularly emerging market growth). Japan needs more policy stimulus.


BOJ is FAR from reaching the limits of monetary policy


More BOJ policy stimulus, this year and beyond…

While the economic trends and risks in Japan appear to follow a well-trodden path, the one notable break with the past is the changed reaction function of the government and BOJ to economic weakness. Abenomics is simply the long delayed application of orthodox economic theory to Japan’s problems and tackles the issue of deflation with an appropriate level of aggression. The policy mix is not without it’s inconsistencies – a delay to the planned 2017 consumption tax hike would markedly improve the prospects of success – but the changed reaction function of the BOJ means that the response to economic set-backs is to floor the accelerator in terms of stimulus. Another round of Quantitative and Quantitative Easing (QQE) – the third – is required, and could be imminent with an expected change to the BOJ’s economic forecasts making its 30th October policy meeting “live”, despite Governor Kuroda’s recent efforts to tone down expectations for an ease. The sheer force of the economic inertia that Abenomics is trying to fight also means that QQE3 may also not be the last of the stimulus. 


…and the BOJ is not compelled to taper in 2016 or 2017

There are two core opponents of the view that the BOJ should provide more stimulus. The first hold to the trickle-down, “virtuous circle” view of Japan’s recovery and hence see no need for further easing. More meaningfully, many believe that the BOJ has reached the limits of monetary policy and may soon need to taper due to a shortage of JGBs to purchase. With the BOJ is buying JPY80trn JGBs a year, which dwarfs net issuance and amounts to 9% of the market and 16% of GDP a year, many argue that the JGB market does not have the capacity to withstand such continued operations, let alone expand them. The argument also states that with the public pension funds having structurally adjusted their asset allocation in favour risk assets, the natural sellers of JGBs to the BOJ have passed, and banks and Lifers are reluctant to sell more.

This analysis is flawed on many levels, as the BOJ has many options it can consider:


JGB purchases – Over JPY200trn to go?

The unusually high level of JGB holdings among Japan’s financial institutions has been a rational response two decades of deflationary impulses. This is not a normal situation, and were Abenomics to succeed far more “risk” assets would be on the balance sheets of buy and sell-side institutions. It would be theoretically consistent for the BOJ to force this trend and spur growth via the portfolio rebalancing effect as capital is chased into higher risk assets. Bank holdings of JGBs for investment purposes measure JPY124trn or 12.5% of their asset base. While this is down from 20% pre-Abenomics, it is far higher than the 5% levels more typically associated in the G10 with risk free/ low risk asset holdings. Japan Post also holds JPY107trn risk free JPY assets or 51% of its portfolio. Outside of the banking sector, Life Insurers, for instance, have 46.1% (JPY161trn) of their assets in JGBs. If the banking sector brings JGB holdings down to 5% of assets, that would release JPY172trn for the BOJ. Meanwhile, the trend towards normalising the domestic/foreign and risk free/ pro-risk asset mix at insurers and pension funds conservatively, has the potential to see JPY40-50trn fewer JGBs held over the coming years.

In short, there is the potential for around JPY220trn (USD1.8trn) of JGB selling to the BOJ. With government issuance of around JPY37trn a year, that provides far more ammunition for QE than the common talk of a forced 2016 taper would presume. The push to reduce the appetite for financial institutions to hold JGBs could be aided by efforts to encourage the development of a securitisation market and hence another source of low-risk assets. This would also have the advantage of creating an additional growth pole in Japan.


Increasingly price sensitive sellers equate to new JGB yield lows

Of course, as financial institutions saw their JGB holdings move towards more towards the levels required by regulatory and collateral need, they may increasingly become price sensitive sellers. Hence, continued QE will increasingly drive JGB yields down to force this selling activity. It remains the worst possible time to undertake the “widow-maker” trade of being short JGBs. The cycle low in yields has yet to be seen.


BOJ can twist…

Even if the BOJ decoded to keep annual JGB purchases unchanged, more impact could be seen from a US-style twist operation whereby the average maturity of purchases increase above the current 10yrs. There would need be little concern about fewer front-end purchases destabilising yields since the prevailing zero rate climate provides a strong roll/carry anchor for the front-end and belly of the curve.


…and go “risky”

There is also the potential for the BOJ to increase further its exposure to risk assets such as equities and credit products. QQE could also help accelerate the development of a securitisation market by providing demand for these products. Providing a tail-wind to the performance of risk assets would help drive the asset allocation among financial institutions away from risk free assets. (Markets love a policy-maker subsidy for asset market returns…)


Foreign asset purchases are politically challenging, and also not needed

The most controversial target for QE would be the purchase of foreign assets by the BOJ, but this would prove a political tinderbox given that the difference between FX intervention aimed at weakening the JPY and the direct purchase of foreign assets is a semantic one. This is an unlikely policy path, but also one that would not be needed. The analysis above already highlights the possibilities for a JPY220trn move out of JGBs over the coming years. Financial institutions need to replace these with new assets, and market depth would argue for a rising foreign portion of assets that replace JGBs. In short, QQE3 would unleash substantial demand for non-JPY assets.


The investment outlook: new cycle highs in USD/JPY/ yield lows in JGBs

At least to me, the investment prognosis for Japan appears reasonably clear. The economy will continue to disappoint and 2% inflation will remain elusive, spurring the need for continued policy stimulus. QQE3 looks highly probable – with the October 30th BOJ meetings a prime candidate for action – and that may not be the end of matters. QQE4 may yet be required, particularly if the government goes ahead with the 2017 consumption tax hike which will once again deliver a body blow to consumer demand.

This places Japan in an interesting position at a time of heightened concerns over global growth and emerging market stability. The Pavlovian response is to anticipate Japan’s economy and markets again being the higher-beta G10 play into a global period of reduced risk appetite, with prolonged Nikkei under-performance and JPY out-performance. However, the policy-response of the BOJ can have the potential to disrupt this relationship.


USD below 120 – time to buy?

The likelihood of additional policy stimulus could help the relative performance of the Nikkei over the coming months. The sheer scale of JPY-selling that will continue to be driven by QQE also argues for a continuation of the Abenomics weak-JPY trade. We are far from the cycle high in USD/JPY, and accumulating USD-longs into the October 30th BOJ meeting/ into the current move below 120 appears attractive. After all, part of recent strength is a broad-USD move weaker as Fed rate hike expectations are rightfully pushed out but Fed tightening is an accelerator not a causal determinant of the trend to a higher USD/JPY. It is in the BOJ’s interests to ensure that the Japanese monetary policy outlook remains considerable more dovish than the Fed’s.


Chart 3. “Old faithful” appears an attractive receive – the JPY IRS 7fwd 3yr


Source: Bloomberg

Old faithful – receive the JPY IRS 7fwd 3yr

As for interest rate markets, a natural ticker-shock precludes many investors from going long at such low levels of yield. However, with the market under-estimating the capacity for the BOJ to maintain it’s stimulus and with sellers of JGBs set to become increasingly price-sensitive, the 0.19% historic low yield for 10yr JGBs looks set to be breached. Holding one’s breath and buying JGBs/ receiving JPY IRS is likely to prove profitable. With the BOJ’s average mature remaining 10yrs, the 20-30yr part of the curve retains a premium (especially as banks tend not to participate this far out along the curve), one which QQE3 or merely a BOJ twist would help erode. The JPY IRS 10fwd 10yr currently yields 1.76%, 20bp above the year low and 97bp above the JPY IRS 5fwd 5yr. This yield looks too high and could move below 1.50% by year-end if the BOJ twists/ unleashes QQE3. Further-in, the old faithful JPY IRS 7fwd 3yr is attractive. This is the pivot point of the JPY interest rate market reflecting how the futures contract is 10yr but where the cheapest to deliver bond is 7yrs. This interest rate can offer initial protection into a sudden sell-off as due to a futures led 7s10s flattening (the slope component of the 7fwd 3yr). At 95bp, the JPY IRS 7fwd 3yr provides 15bp annual slide (which I would expect to be fully captured) and in absolute terms – again – looks to high with yields 20bp above the early-year lows.