It seems like a long time since I have been able to sit in my favorite coffee shop in Shibuya, Japan, to write our blog. Not far from the famous Shibuya Scramble, one of the busiest intersections in the world, with thousands of people crossing that intersection when the light turns red. Some very nice cars drive through that intersection when the light turns green. As I write our next blog, drinking a cappuccino, I suggest grabbing your favorite beverage as this will be a long, in-depth blog. We will time travel across an economic scramble together. We will go back to the 1970s and 1980s, then return to the future- 2023. In short, we are bullish on the Japanese stock market and economy. As a secondary thesis, we are bullish on the U.S. economy and cautious about the U.S. stock market. However, do not worry if you find it hard to follow this long path, as we are making videos to capture the essence of this blog.
The market in Japan peaked 30 years ago and has not seen the price it once reached back then. The same can be said for their real estate market. One might think that Japan has been in a recession for over 30 years; however, its GDP has been growing steadily. Of course, they had some recessions along the way. Once, it was the number two economy in the world. Now, it is the third-largest economy. An important distinction exists between a country's economy, real estate, and stock markets. While they are related, they are just not the same. We think this will be clear by the end of this blog.
We believe there are green shoots in Japan, and it is time to dive deeper into their economy and stock market. First, we will begin with a historical review to put things in perspective.
We can already hear a few objections being parroted: Japan's population is declining, a weak yen, and a high debt to GDP. We believe these issues are being addressed, and Japan will thrive for many years.
Nikkei 225:
"The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, when the average price was ¥176.21 with a divisor of 225. *We are using an official divisor for this index." Bloomberg
Think of their Nikkei 225 as a benchmark like our Dow 30 or S&P 500. An understanding of the historical performance of the Nikkei is paramount to the Thesis of our blog.
In 1986, the Nikkei closed at 18,820. In just a few years, it would double. In 1989, the Nikkei 225 would hit an all-time high of 38,915 on December 29, 1989. It had a price-to-earnings expansion, and the price-to-earnings ratio (P/E) was about 60.
Thirty years later, it has seen that price level again, and the P/E today is about 20.
Please see the chart:
(Created by Jonathan V. Bever. Data source: Bloomberg)
From 1970 to 1989, the general trend of the Nikkei 225 was up. (Looks like climbing up Mt Fuji.) A passive investor would have done well until the day things changed. If one does not understand investing and the attributes that drive performance, how would one know when to exit a winning investment such as investing in the Nikkei? How do you walk away from an investment which worked for twenty years or longer? The Nikkei would enter a long-term bear market, and passive investors would not be rewarded for years. The factors which caused the change, the paradigm shift, should be understood if one wants to understand investing and avoid a lost decade or two of return on investments. While this blog is primarily about Japan, we are going to make comparisons to our S&P 500. We are not suggesting our market is going to follow suit. We recommend being aware so you don't waste time making up your performance. Japan's 80s valuation of risk assets would be considered a bubble. The expansion turned into a contraction lasting many years. The Nikkei would close around 8109 on March 31, 2009, and real estate is nowhere near the price it once reached. (Climbing down Mt. Fuji).
Please see chart: Nikkei 1989-2009
(Created by Jonathan V. Bever. Data source: Bloomberg)
Finally, here is the longer-term view of the Nikkei 225. The red line is the Nikkei, and the black line is the P/E ratio. Please see the chart:
(Created by Jonathan V. Bever. Data source: Bloomberg)
Lost Decade: two quotes from Wikipedia:
"In Japan during the 1980s, the economy was booming, where buyers paid the highest prices for goods and commodities. As of March 1980, the unemployment rate in Japan was 4.9%;[1] a meager number compared to the unemployment rate during the height of the 1990s. The following decade would see Japan's economy decline substantially, giving rise to the " Lost Decade." Wikipedia
A low unemployment rate, high cost of living (CPI), and robust GDP: Does this remind you of a local economy?
"By the late 1980s, the Japanese economy experienced an asset price bubble of a massive scale. The bubble was caused by the excessive loan growth quotas dictated on the banks by Japan's central bank, the Bank of Japan, through a policy mechanism known as "window guidance. " Wikipedia
Due to a strong economy, Japan had high inflation, overvalued assets, and loans against those assets. Eventually, the bubble would deflate, and for many years, Japan would manage the menace of deflation.
Please see the Consumer Price Index for Japan: top line: Japan CPI. Bottom line: Japan Prime Rate
In the 1970s, the CPI was around 20%, and by the end of the 70's went down to about 3 %. In the 80s it fluctuated between 3% and a slightly negative number. On a longer-term basis, the CPI would be slightly positive to slightly negative; recently, it has reached 3.2 percent, which is not too hot or cold. Goldilocks!
Please see the Consumer Price Index for Japan 1975-1995: top line: Japan CPI. Bottom line: Japan Prime Rate.
(Created by Jonathan V. Bever. Data source: Bloomberg)
We cannot stress the importance of understanding the factors that drive investment performance. High valuations can lead to even higher valuations and tempt one to chase performance. For a while, it may look wise to pursue hot investments. However, when those valuations get reset to their longer-term averages, it will be "smart" in that it hurts.
The late stages of high returns in the Nikkei225 concern us regarding potential parallels in our market. Will the cause of the unwinding of the high valuations in the Japanese market and real estate happen here?
Regarding the Nikkei 225 doubling between 1986 and 1989, it wasn't just an expansion of the P/E ratio as their GDP doubled as well. Japan was the second-largest economy after the U.S. economy.
See the chart: Japan's nominal GDP is on top, and the U.S. nominal on the bottom.
(Created by Jonathan V. Bever. Data source: Bloomberg)
Japanese Economic Miracle
By the end of the 1980s, Japan's economy was so strong it was given the monicker "The Japanese economic miracle." It had become the second-largest economy in the world and produced some of the most recognized household franchises.
In 1989, thirteen of the twenty largest global companies based on the market cap were Japanese. Many are still household names; however, zero Japanese companies are in the top 20 world's largest companies based on market cap. In contrast, 15 of the largest companies based on the market cap are U.S. companies.
Japan's historical economic strength
Here is a concise summary of the historical economic strength and asset bubbles in Japan:
Devil Take the Hindmost by Edward Chancellor.
"From 1956 to 1986, land prices increased 5000% even though consumer prices only doubled.
In the 1980s, share prices increased 3x faster than corporate profits for Japanese corporations.
By 1990, the total Japanese property market was valued at over 2,000 trillion yen or roughly 4x the real estate value of the entire United States.
The grounds of the Imperial Palace were estimated to be worth more than the entire real estate value of California or Canada at the market peak.
Over 20 golf clubs cost more than $1 million to join.
In 1989, the P/E ratio on the Nikkei was 60x, trailing 12-month earnings.
When things are going exceptionally well, it is nearly impossible to imagine things coming to an end, but they do. As we quoted in our last blog: "If something cannot go on forever, it will stop." (Herbert Stein). So, what makes it stop, and can it be predicted? What brought the party to an end in Japan should give us some insight. We can look back and say it was an obvious bubble in the stock and real estate markets, and no bubble will last forever. You can be sure there were many bears along the way calling for an end, but year after year, they would be wrong. When the animal spirits are frothy, and things are humming, it is hard to imagine that things will end or slow down or that there will be a paradigm shift. Hence the title of our blog: Imagine.
Dangers of a Strong Currency
Here, we will consider how a currency exchange rate affects an economy. Yes, it might sound tedious, but we want to learn from history rather than be a casualty as it repeats.
One of the reasons attributed to the recession of 1990 was the strength of the Yen. Japan became the second-largest economy but not the largest. A strong economy and healthy interest rates make a country's currency attractive.
Endaka Fukyo (recession caused by strong Yen)
Endaka (Japanese: 円高, lit. yen expensive) or Endaka Fukyo (Japanese: 円高不況, lit. yen expensive recession) is a state in which the value of the Japanese Yen is high compared to other currencies. Since the economy of Japan is highly dependent on exports, this can cause Japan to fall into an economic recession. Wikipedia
One of the reasons attributed to the recession of 1990 was the strength of the Yen. Japan became the second-largest economy but not the largest. A strong economy and healthy interest rates make a country's currency attractive.
Please see the chart:
(Created by Jonathan V. Bever. Data source: Bloomberg)
The blue line is the prime rate in Japan. The red line is the yen spot price in reference to the U.S. Dollar exchange rate. While it looks like the Yen is going down, it is going up. What is going down is the number of Yen you get for a dollar. The chart represents how many Yen you can get in exchange for your U.S. dollars. So, the lower the Yen on this chart, the stronger the Yen is because you get fewer yen with your dollar. You can see in the 1970s, an average of 300 yen in exchange for the dollar and half that amount to 150 by 1990. Essentially, the Yen doubled in value. Okay, so what? Let's get some insight from The Plaza Accord.
Why did the Yen get so strong and wreaked havoc on their economy?
In 1985, there was the Plaza Accord, which you have probably never heard of. In short, the U.S. wanted to increase its exports and stimulate its economy. If a country's currency is weak, the exchange rate makes the exports more attractive to foreign buyers. If natural forces are against you, then what? Then you either live with it or create a Plaza Accord to devalue the U.S. Dollar by getting multiple countries to participate.
Plaza Accord
The Plaza Accord was a joint–agreement signed on September 22, 1985, at the Plaza Hotel in New York City, between France, West Germany, Japan, the United Kingdom, and the United States to depreciate the U.S. dollar in relation to the French franc, the German Deutsche Mark, the Japanese Yen, and the British Pound sterling by intervening in currency markets. The U.S. dollar depreciated significantly from the time of the agreement until it was replaced by the Louvre Accord in 1987.[1][2][3] Some commentators believe the Plaza Accord contributed to the Japanese asset price bubble of the late 1980s.[4][5][6] Wikipedia
The strength of the Yen has been attributed to one of the causes of the bubble in the stock market and real estate market on the one hand and the other cause of the bust.
We think stability is the most important issue with currency or any commodity. If the price is stable, then it is easier to make an economic plan accordingly. If there is a significant disruption to a country's currency or a commodity such as oil, then this disruption will cause problems much like a tsunami. The Louvre Accord did just that as it ended the Plaza Accord in 1987, which took place in France.
Let's look at Japan's GDP as a percentage of growth. Please see the chart:
(Created by Jonathan V. Bever. Data source: Bloomberg)
In 1985, the strong Yen slowed the Japanese economy. By 1991, the growth of the Japanese GDP would drop below zero. Interest rate hikes or cuts take several months to be felt in the economy; likewise, a country's currency strength or weakness takes months to see the effects.
Weak Yen
The U.S. has a strengthening dollar as our Fed began one of its most aggressive rate hike cycles beginning in 2022. On the other hand, Japan has weakened its currency, increasing concerns over how its Central Bank will handle inflation.
Please see chart: The red line is the Japan yen exchange rate.
(Created by Jonathan V. Bever. Data source: Bloomberg)
The Japanese yen exchange rate increase shows weakness in the Yen. Simply put, you get more Yen for the dollar when you exchange. This means tourism should pick up as it might be less expensive than traveling to Europe or the U.S. Likewise, buying items Japan exports will probably be more competitively priced, such as cars, cameras, etc. If a too-strong yen slowed the Japanese economy, wouldn't a weakening yen stimulate their economy? The answer is yes if they can manage crude oil and labor inflation. As CPI increases (the cost of living), workers will need an increase in wages. The weak Yen will make the price of crude oil go up.
Largest Economies Birth Rate
(Created by Jonathan V. Bever. Data source: Bloomberg)
You can see the birth rates in the U.S., China, and Japan have been going down for years. It takes over two children per couple to keep a county's population from going extinct. Japan has been focused on addressing the issue. According to this chart, Japan's birthrate is forecasted to level out and eventually grow. As a side note, companies have increased productivity and offset wage inflation with automation and technology.
S&P 500 Parallels to peak Nikkei 225
Imagine: Durudaka Fukyo (strong dollar recession) Doru-ko Fukyo.
We are cautious about the performance of the S&P 500 for several reasons. The S&P has a high P/E ratio of around 20 when the longer-term average is about 16. A P/E ratio of 20 is not high enough to suggest a decline of more than 20 percent based on the current environment. However, some stocks driving the performance year to date have high P/E ratios of 30-60. A low-interest rate environment will support an above-average P/E ratio. Now, we are in a higher interest rate environment with possibly years to come of higher rates. In a prior blog, we pointed out that P/E ratios on the S&P will go up or down based on interest rates: see blog:
The doubling of S&P from December 2018 to December 2021.
Out of the world's largest companies by market cap, 15 out of 20 companies are U.S. based. The Fed raising rates to fight inflation has strengthened the U.S. Dollar against many other currencies. Are we about to go the way of Endaka Fukyo (strong yen recession)? In our case Doru-ku Fukyo (strong dollar recession)?
Even if inflation continues to moderate, the Fed is not guaranteed to lower rates. It will slow the rate hikes and possibly pause, but rate cuts are not on the horizon, in our opinion. Now, if we have a recession and the Fed can justify lower rates, then ironically, this may be the best-case scenario for stocks in the U.S. However, inflation may go back up faster than expected. We must monitor this as the paradigm shift of higher rates and the inflation cycle plays out here.
Japan's Positive Yield Curve
When it costs more to borrow in the long term and less short term, this is considered a normal and positive sign of economic growth.
Of course, economic cycles have peaks and troughs, and no monetary policy can change that. When examining economic bubbles, the peaks and valleys are enormous. When a cycle turns down, it can be vicious: declining GDP, stock, and real estate prices. The Central Bank of Japan has fully accommodated economic growth for decades as it fought deflation. Finally, the CPI has picked up in Japan, and rates have increased slightly. The 10-year (JGB) Japanese Government Bonds: Govt 10-year bond went from a yield of negative -0.277 in 2019 to a positive 0.3865 percent currently. The short-term yield is -0.10%. A steepening yield curve is a good sign for an economy. Of course, if their CPI gets too hot, seeing how high rates will go in Japan will be interesting. We see inflation moderating for now as crude oil is well off its high from a year ago. Labor is the inflationary variable to watch in Japan and the U.S.
Please see the yield graph:
(Created by Jonathan V. Bever. Data source: Bloomberg)
Nikkei 225 Recovery
Notably, the Nikkei 225 is now at 30,093, well above its low in 2009. The current P/E ratio is about 20. In a low-rate environment, this is a reasonable P/E ratio. With an earnings growth rate of about ten percent per annum for the next two years, we believe in the next 18 months, the Nikkei may finally fully recover!
Here in the USA, our Fed bank policy was highly accommodating to the economy but changed as inflation got too high, and now their policy is restrictive to fight inflation. Our Fed is reducing its balance sheet and is in a rate hike cycle.
Let's look at the Central Bank of Japan's balance sheet as a percent of GDP and GDP.
(Created by Jonathan V. Bever. Data source: Bloomberg)
Japan finally has more robust inflation after many years of deflation. The Central Bank balance sheet reached 130 percent of GDP, and its rates were nearly zero. Extremely low rates and the need to continuously increase its balance sheet are not a harbinger of a robust economy. In the U.S., when our Fed increases its balance sheet to stimulate the economy, we call it Quantitative Easing. So, has Japan crossed over from deflation to inflation as we have in the U.S.? Are the interest rates going to move slowly higher in time? Yes, we think so for both questions.
Summary:
For many years in the 1980s, Japan had a super-hot economy, residential real estate, commercial real estate, and stock market. Of course, they had a high CPI and low unemployment rate. After their Yen became very strong, the excessively high-priced Nikkei and real estate prices decreased. Bubbles in asset prices are understood in hindsight. It is difficult to call a bubble in the middle of its cycle. When bubbles pop, recovering from deflated prices takes a long time. They have been fighting deflation for a long time.
Some issues plaguing Japan concern us with our economy and stock market. So, we are cautious about the U.S. stock market as there are parallels to Japan in 1989. We have a strong dollar as our Fed raises rates to fight inflation. Our unemployment is low. Our yield curve is inverted, suggesting a possible recession. A strong dollar could take a couple of years to realize its effect on our economy, so we are modestly bullish for the next eighteen months. While our S&P 500 has a P/E ratio of around 20 and not the high 60 of the Nikkei in 1989, the companies driving its performance have much higher ratios. High mortgage rates and high vacancies in commercial real estate leave us cautious about those markets.
Bullish on Japan
Finally, Japan is not fighting deflation, at least regarding their CPI, which is now around three percent. Currently, their CPI is a healthy number, not too weak or too strong; likewise, the Yen is not too strong or weak. A weak yen should stimulate their exports. Interest rates are low in Japan, and they have a "normal" yield curve. We believe the excess P/E ratio of the Nikkei 225 has been worked through and think it will recover to its all-time high within a couple of years. After 30 years, there are green shoots in Japan, and we are bullish. After all, Godzilla always makes a comeback!
Definitions
Nikkei 225:
"The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, when the average price was ¥176.21 with a divisor of 225. *We are using an official divisor for this index." Bloomberg
CPI
The Consumer Price Index (CPI) measures the monthly change in prices paid by U.S. consumers. The Bureau of Labor Statistics (BLS) calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate U.S. consumer spending.1
The prime rate is the interest rate commercial banks charge their most creditworthy customers. The Federal Reserve System sets the federal funds overnight rate, which serves as the basis for the prime rate, which is the starting point for other interest rates.1
The prime rate, sometimes called prime, is the benchmark banks and other lenders commonly use when setting their interest rates for various products, such as credit cards and home loans.
Yield Curve:
A yield curve is a line that plots yields, or interest rates, of bonds that have equal credit quality but differing maturity dates. The yield curve's slope can predict future interest rate changes and economic activity.
There are three main yield curve shapes: normal upward-sloping curve, inverted downward-sloping curve, and flat.
The prime rate is the interest rate commercial banks charge their most creditworthy customers. The Federal Reserve System sets the federal funds overnight rate, which serves as the basis for the prime rate, which is the starting point for other interest rates.1 Investopedia
Central bank balance sheet:
The central bank balance sheet is one of the forms of reporting by the country's central bank, which reflects the state of its allocated, borrowed, and owned funds as of a specific date. The central banks of most countries in the world calculate and publish balance sheet data monthly (for example, in Austria, Japan, Poland, Russia, Luxembourg, the Netherlands, and Mongolia). In many countries, the central bank balance sheet is published quarterly (for example, in Estonia) and weekly (in Australia, Eurozone, the U.K., and the USA). Today, the balance sheet is actively used by central banks in their monetary policy, in particular, in the formation of its transmission mechanism. The central bank's balance sheet consists of assets and liabilities. The table below shows the classic structure of a country's central bank balance sheet. Cbonds Glossary.
Japan Central Bank Balance Sheet:
Bloomberg:
As of 1/29/2016, BOJ employed "Quantitative and Qualitative Monetary Easing with a Negative Interest Rate" in their monetary policy. Please read the following link for further information http://www.boj.or.jp/en/announcements/release_2016/k160129a.pdf As of 04/04/2013; the BOJ has shifted its monetary policy focus to a targeted monetary base via Japanese government bond (JGB) purchases. Please refer to: http://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf (English). As a result, there will be no prices updated after April 4, 2013. For monetary base outcome, please refer to ALLX BOJT< G.O.>. For the Actual result of the Overnight call rate, please see MUTKCALM Index DES< G.O.>.
Please refer to BOJ for the rate on 10/5/10. The rate displays the high range value in H.P. During the period of 03/19/01 through 03/08/06, there was no formal recommended target rate. During that period, the main operation target changed from the overnight call rate to the outstanding balance of the current accounts.
The BOJ introduced regularly scheduled monetary policy meetings and the publication of meeting minutes beginning in 1998. From 1998 till 1972, the target rate is updated weekly.
Plaza Accord:
The Plaza Accord was a joint–agreement signed on September 22, 1985, at the Plaza Hotel in New York City, between France, West Germany, Japan, the United Kingdom, and the United States to depreciate the U.S. dollar in relation to the French franc, the German Deutsche Mark, the Japanese Yen, and the British Pound sterling by intervening in currency markets. The U.S. dollar depreciated significantly from the time of the agreement until it was replaced by the Louvre Accord in 1987.[1][2][3] Some commentators believe the Plaza Accord contributed to the Japanese asset price bubble of the late 1980s.[4][5][6] Wikipedia
The Louvre Accord:
(formally, the Statement of the G6 Finance Ministers and Central Bank Governors)[1] an agreement signed on February 22, 1987, in Paris, aimed to stabilize international currency markets and halt the continued decline of the U.S. dollar after 1985 following the Plaza Accord.[1] From a relational global contract viewpoint, it was considered a rational compromise solution between two ideal-type extremes of international monetary regimes: the perfectly flexible and the perfectly fixed exchange rates.[2]
Canada, France, West Germany, Japan, the United Kingdom, and the United States signed the agreement.[1] The Italian government was invited to sign the deal but declined.[1] Wikipedia
Replacement level fertility:
PIP: Replacement level fertility is the level of fertility at which a population exactly replaces itself from one generation to the next. In developed countries, replacement-level fertility can be taken as requiring an average of 2.1 children per woman. In countries with high infant and child mortality rates, however, the average number of births may need to be much higher. Replacement level fertility is not associated with a unique set of age-specific birth rates. NIH National Library of Medicine. J Craig.
Disclosures:
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not consider the effects of inflation and the fees and expenses associated with investing.
Investment advisor representative of securities and investment advisory services offered through Cetera Advisor Networks LLC, member FINRA/SIPC, a broker/dealer, and Registered Investment Advisor. Cetera is under separate ownership from any other named entity. In addition, some Investment advisory services are offered through Fulcrum Wealth Advisors, LLC. Fulcrum Wealth Advisors, LLC is a registered investment advisor in the State of Washington.
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