What Japan, 1990-2008,Can Tell the US about its Future?

John Richards

April, 2012

Introduction: Caveats

Part 1. Making sense of what happened in Japan 1990-2008

Part 2. Focus on Japanese Asset prices

Part 3. Conclusions and implications for the US,

especially US asset prices

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Why study Japan? Important in its own right.

• Japan is the world’s second or third largest economy; population 126 million.

• Japan is “rich.” Per Capita income USD 42K.

• Japan is a major source of global savings. Current account surplus of around USD150 bn per yr.

• Japan’s households’ financial assets are about the same as those of France and Germany combined.

• Japan is of tremendous strategic importance to the US in Asia.

• Japan’s population is aging rapidly and shrinking absolutely.

• Japan has the developed world’s highest government debt burden (nearly 200 percent of GDP) and highest dependency ratio.

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Why Japan 1990 to 2008: the world’s longest running experiment on financial crises, what to do about them, and what happens after the crisis ends.

• asset bubbles: how do they happen?; what happens when they burst?

• when cyclical downturn and financial crisis coincide

• deflation

• deleveraging

• operational restructuring by business

• labor force flexibility

• zero interest rate monetary

• quantitative easing

• communication of monetary policy objectives to the market

• large government deficits and massive fiscal stimulus

• fiscal consolidation

• bank recapitalization via public funds

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Caveat: Can history really tell us anything?

“Those who cannot remember the past are condemned to repeat it.” George Santayana

“History … is the big myth we live.” Robert Penn Warren

“[History] is just one damned thing after another.” Arnold Toynbee

“History repeats itself because no one was listening the first time.” Anonymous

“History is written by the winners.” Alex Haley

My personal favorite: “History never repeats itself; at best it sometimes rhymes.” Mark Twain

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Part 1: Making sense of what happened in Japan

Caveat: Differences between Japan in the ‘90s and the US in ‘08

• Japan’s problems in the ‘90s were quantitatively larger than those in the US in 2008.

• Crisis centered in different sectors: Japan: banks, commercial real estate, business. Households were unaffected. US: households, residential real estate, banks and related financial entities. Business in good shape.

• Recognition/reaction speeds. Japan recognition time very slow (7 yrs). US the financial crisis and the economic downturn coincided – sense of crisis was almost immediate.

• Policy response. Initial policy responses were slow and weak in Japan. They were relatively quick and decisive in the US.

• Private sector responses. Japan’s businesses and banks were slow to respond; in the US, businesses aggressively restructured and banks recapitalized quickly.

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To better understand Japan, I divide the last two decades into distinct periods.

1990-1997: Denial

1997-2002: Restructuring

2002-2008: Earning-Led Growth

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Prelude to the crisis

• Economic growth averaged around 4% in the 80s, 6% in the 70’s, 8% in the 60’s.

• ‘80s growth increasingly fueled by highly accommodative monetary policy, lax bank-lending standards, and excessive business borrowing.

• Japanese equity prices tripled and land prices, which had been rising steadily for decades, surged 30% between 1985-1990.

• The bubble burst in 1990. Peak to trough, both Japanese equity and land lost around 80% of their values!

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1990-1997, Denial or “if things are so bad, why don’t I feel worse?”

• Real GDP grew at around 2%

• Households not highly leveraged

• Household spending grew at around 3.6% per year

• Businesses still hoarding labor

• Unemployment rate averaged 2.7

• Regulatory forbearance for the banks

• Banks kept “zombie” companies alive

• Convoy system for dealing with failing financial institutions

• Easing monetary policy and doses of fiscal stimulus

• 10yr JGB yields fell from 5% to 2%

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1997-2002, Japan Restructures

• 1997-1998: The financial crisis emerges

• Collapse of Yamaichi and Hokkaido Takushouku Bank were too big for the convoy system to handle

• Ill timed fiscal consolidation raises taxes

• Credit markets freeze up

• Japan premium rises to 80 bp in international markets

• Equity cross holdings and land as collateral hurt bank capita

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The government responds, slowly at first, but then forcefully.

• The BoJ eases aggressively.

• MoF guarantees all bank deposits and interbank transactions.

• Fiscal consolidation abandoned; more fiscal stimulus.

• Public funds forced on the banks.

• Nippon Credit and Long Term Credit Banks nationalized

• FSA empowered to nationalize any bank that did not submit satisfactory restructuring plans.

• Non-performing loans dealt with.

• Zombie companies liquidated.

• Government work out agencies established to buy troubled assets from the banks, including equities. Cross holdings reduced. Tough new accounting standards applied.

• Banks consolidated into today’s mega banks.

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Greatest changes in the private sector

• Business restructures, largely eliminating the three excesses: debt, capacity, labor.

• Business re-engineers itself to be complimentary to rather than competitive with the Chinese economy.

• Labor market flexibility increases and life time employment ends.

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The economy really suffered

• Real GDP was barely positive or negative in 4 out of the 5 restructuring years

• Deflation gets a toehold

• Unemployment rate doubles to more than 5%

• Suicide rate rises by 50%

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But much was gained.

• By the end of 2002, Japan was well positioned for more sustainable growth.

• China’s huge fixed capital investment spending lit the fuse.

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Earnings-led growth

Least studied, but most important of the three regimes in terms of understanding the US today.

2002-2008: Japan’s longest uninterrupted expansion in modern times.

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Japan

Japan Real GDP Growth, 2002-2008 (Q/Q Annualized)Source: RBS

Source: Bloomberg

Decomposition of earnings-led growth: capital spending and exports lead; consumption lags.

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Capital Spending, Exports, Consumption (Growth rates Q/Q annualized)

Source: Bloomberg

Corporate earnings growth surges when operating leverage kicks in (2003-2007) and falls when import prices soar (2008).

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Corporate Earnings Growth (YoY, %)

Source: Bloomberg

Characteristics of earning-led growth in Japan

• Operating leverage

–key to understanding earning-led growth

–Restructuring lowers costs

–Sharply improves the relationship between top-line revenue growth and bottom line earnings growth

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Vulnerability to higher input prices (fuel): Note transition from balanced growth to export dependency as terms of trade deteriorate.

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Contribution to GDP Growth by Sector

Source: Bloomberg

To sum up: key features of earning-led growth

• Improved operating leverage drives earnings.

• Earnings growth drives the economy.

• Growth highly sustainable, but slow.

• Exports strong.

• Consumption, employment weak.

• Vulnerable to deteriorating terms of trade.

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Part 2. Focus on asset prices

10yr JGB yields. Rates tend to be range bound at historically low levels despite high deficits and excess liquidity. Why?

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10-yr Japanese Government Bond Yields

Source: Bloomberg

Business behavior changed: Inventory/Shipment Ratio: exceptionally stable, helping to keep credit demands subdued.

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Inventory/Shipment Ratio

Source: Bloomberg

Businesses keep capital spending in line cash flow so a “financing gap” never emerges despite years of steady growth.

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Free Cash Flow vs Capital Spending

Source: Bloomberg

Bank Lending Growth – Negative when business were deleveraging and barely positive thereafter.

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Bank Lending: YoY Growth

Source: Bloomberg

Restructuring unleashes persistent, if mild, deflationary pressures.

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Core CPI (includes energy) and CPI less Food and Energy

Source: Bloomberg

Yield Curve Dynamics

Japan’s monetary policy: unconventional then, less so now.

• ZIRP

• Liquidity

• QE

• Communication

• Unconventional Asset Purchases

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Yield Curve Dynamics

• Trend – Rolling flattening

• Tactical – Strong directionality, steeping in sell offs and flattening in rallies

• Episodial – Duration grabs (and dumps)

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Yield curve dynamics when the policy rate is pegged: rolling flattening is the long-term trend.

Source: RBS, Bloomberg

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Volatility relatively low but with sharp spikes

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Source: Bloomberg, RBS

Japan 10yr Swap Spreads: Depend on the interplay of of credit, balance sheet constraints, and relative supply-demand conditions. Movements may be counterintuitive.

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Yen Swap Spreads

Source: Bloomberg

Credit spread narrow even as risk free yields fall in an earnings-led growth regime.

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Source: Bloomberg

Japan Credit Spreads and JGB Yields

US credit spreads have room to compress significantly further if they follow Japan’s trajectory.

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US Credit Spread (ratio) vs US Treasury Yields

Source: Bloomberg

Part 3.Conclusions and Implications for the US

Implications for the US

• Denial: quick recognition and aggressive action needed. Avoid premature fiscal consolidation and tightening of credit.

• Restructuring: Fix the banks. Growth will be constrained by bank capital until you do. Banks will resist share dilution. Prefer to ride a steep yield curve. Restructuring on the business side is likely to be painful and deflationary. Inflation low for a long period of time.

• Earnings-led growth most relevant for the US now.

• Operating leverage persists long after aggressive restructuring comes to an end. This means earnings level off at a high level.

• Equities: Should see S&P at 1700-1800 over the next 2 years. Usual exogenous risk factors are the caveat.

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Implications for the US (cont.)

• Interest rates: Likely to be range bound. Business caution will keep spending in line with free cash flow postponing clash between private and government borrowing.

• Yield curve features: strong directionality, a rolling flattening trend, and episodes of duration grabs and dumps.

• Volatility: Low but featuring extreme spikes.

• Swap spreads: Watch out for counter-intuitive moves.

• Credit spreads: Will feature the “great compression” to extremely tight levels. Low absolute rates are not a barrier in the the long run to compression.

• High yield looks especially attractive right now. Most room to compress and enjoys an equity kicker.

• USD: Dollar friendly

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