In this Age of Monetary Policy, it is impossible to ignore the macro. As much as we would like to focus only on individual enterprises, the mind-boggling scale of $5 trillion of monetary intervention in the U.S., Japan, and Europe renders such cloistered thinking imprudent. Not only must Benjamin Graham’s enterprising investor understand individual stocks, but they must also be keenly cognizant of the role the world’s largest central banks actively play in the value of currencies, bonds, stocks, ETFs, mutual funds, and derivatives of all kinds.
With the re-election of Mr. Abe as Prime Minister this past December, the Japanese have embarked on the monetary equivalent of a “banzai charge” – an all-or-nothing attack on one’s enemy which either ends in victory or the complete exhaustion of any remaining resources – to jump start the Japanese economy. The term "banzai" means “10,000 years” in Japanese and is part of the cry “Tenno Heika Banzai!” or, literally, “May the Emperor Live 10,000 years!” The origin of strategy is said to be traceable to a 7th century Chinese text called the Book of Northern Qi, which states that "A man would rather be a shattered jade than be a complete roof tile." It is similar to the Western sentiment that it is better to die on your feet than live on your knees.
Since announcing his “Three Arrows” plan in 2012, Prime Minister Abe has been able to implement Arrow 1, or monetary easing, in the form of quantitative easing, get part of Arrow 2 in flight, raising the consumption tax, i.e. sales tax, from 5% to 8% as an intermediate step to an ultimate 10% level, while Arrow 3, labor and agricultural reform, has remained firmly stuck in his quiver. In an attempt to break the political logjam facing him with regard to the remainder of Arrows 2 and 3, Mr. Abe called a snap election for December of 2014. His gamble paid off with blockage-proof majority in Japan’s Diet, meaning that “Qualitative and Quantitative Easing Part 2” or “QQE2” is now charging ahead.[1]
In terms of grasping the scale of Japanese monetary ambitions for QQE2, here are the specifics:
· By 2016, Mr. Abe and his cohort at the Bank of Japan, Mr. Kuroda, plan to nearly quadruple the size of Japan’s monetary base (the currency in real and notional forms) to ¥355 trillion or about $3 trillion of currency or equivalents in circulation. This increase will take Japan’s monetary base from 28% of GDP in 2012 to nearly 90% of GDP in 2016. As a basis for comparison, the United States monetary base is 23% the size of U.S. GDP.
· At the same time, the Bank of Japan (the equivalent of the U.S. Federal Reserve) will continue to purchase securities in the open market, expanding its balance sheet to ¥380 trillion (again, about $3 trillion) or 75% of Japan's GDP. For comparison purposes, the Federal Reserve has expanded its balance sheet to nearly $5 trillion over the past 5 years as part of QE1, QE2, and QE3, but the difference is that the Fed’s balance sheet is only about 33% the size of U.S. GDP.
· To achieve this balance sheet expansion, the Bank of Japan will increase the scale and pace of its Japanese Government Bond purchases from around ¥60 trillion per annum ($500 billion) to ¥80 trillion per annum (about $666 billion), meaning that the Bank of Japan will own some 40% of all outstanding Japanese government debt.
· Japan’s Government Pension Investment Fund (GPIF), the largest single pension fund in the world with $1.2 trillion in assets and accounting for almost 10% of global pension fund assets, plans to do its part by increasing its allocations to Japanese and Foreign equities to 50% of total portfolio holdings, or roughly $600 billion in total. This represents a doubling of the Bank of Japan’s equities exposure and an incremental $300 billion entering equity markets. In addition, it plans to increase its foreign bond allocation to 15% of the total portfolio, leaving the remaining 35% in Japanese government debt.
Since the initiation of Mr. Abe’s first wave of QE in 2012, the Yen/Dollar exchange rate has fallen from 80 Yen per Dollar to nearly 125 Yen per Dollar, making Japanese exports to the U.S. as much as 50% more price competitive during that period. And, note, this decline may not reflect the full impact of the remaining 2 or so years of QQE2. Even with that boost to trade and a brief surge in growth to a 4.3% in Q1 2013, the Japanese economy began backsliding thereafter and fell into a full blow recession in Q2 of 2014, thus necessitating Mr. Abe’s snap election of December 2014 and the supersizing of Japanese QE to QQE2.
It should not be surprising that it is easier to crank the printing presses and change the investment policies of the pension funds than it is to enact either fiscal or societal reform. The Japanese are in this regard no different to the United States and the Federal Reserve’s QE1, QE2, QE3, and deliberately compressed interest rates. The only difference would be in terms of scale and longevity - the Japanese have been quantitatively easing and compressing interest rates going back to the 1990’s.
All that said, we do not believe Japan’s monetary banzai charge alone can produce the economic rates of growth desired by the Abe Government because Japan’s lack of growth is not due to a lack of monetary base or available capital, but results instead from the simple math that the Japanese are dying off at a significantly faster rate than they are being born. Combining this imbalance with massively restrictive Japanese immigration laws and the result is a growing elderly population dependent upon Government pensions and healthcare with a shrinking workforce that foots the cost of those programs.
This past year Japan experienced its lowest number of live births since World War II, about 1.0 million. At the same time, elderly Japanese are passing away at a rate of about 1.3 million per year, leaving a reduction of about 300,000 in population per year. That is the equivalent of losing one City of Pittsburgh (population: 306,000) per year. This trend has been projected to continue to the year 2030, thanks to the ongoing reduction in numbers of child-bearing age women in Japan, meaning that over the next 15 years, Japan will lose the equivalent population of the State of Louisiana (about 4.5 million residents).[2]
But a falling population alone should not necessarily spell doom for Japan or any of the other shrinking and aging developed economies (Finland, Ireland, Sweden, and Italy come to mind). The critical and core problem for Japan is the inverted pyramid of many retirees versus the fewer taxpaying workers which places an enormous strain on a shrinking tax base to support an increasingly heavy social spending burden. To put some numbers to this, it is estimated that the Japanese working age population will decline from 82 million in the year 2010 to 68 million in the year 2030, a reduction of 14 million workers or 17%. This works out to about a 1% annual decline in working age population over the next 15 years, meaning that whereas today you have 4 workers for every 1 retiree, in 2030 there will be only 3 workers per 1 retiree. Japan’s fiscal challenge is that unless retiree benefits decrease in real terms, the tax burden per worker must increase in real terms.
If there is a good argument for the aphrodisiacal effects of monetary and fiscal policy which can produce a generation of Japanese who are eager to be fruitful and multiply, we are open to hearing it.[3] Although Milton Friedman famously wrote that “inflation is always and everywhere a monetary phenomenon” it does not necessarily follow that deflation is likewise a phenomenon of the lack of money supply.
Rather, it does not require a PhD in Economics to see and understand the obvious corrosive economic effects of an essentially sealed-off aging island nation with a falling birthrate: growing internal consumption is plainly a problem when the consumers themselves are dying off faster than they are being born. Economic incentives appear to have limited efficacy in the face of societal and cultural dynamics: Italy has numerous tax incentives for producing children and Italians, fairly or unfairly, are thought of as an amorous people, and still Italy finds itself just a few steps behind Japan in the aging population international rankings.
And yet, despite its population problems and its QQE2 banzai charge monetary policy, are we making a negative call on Japan and predicting the imminent or even ultimate demise of the Yen?
Absolutely not. This is not a thematic call to short Japan, flee Japanese stocks, or to herald the demise of the Japanese. It should be an issue at the top of anyone’s list who holds Japanese debt, equities, or Yen-denominated assets. While Japan has struggled to adjust both to a mature population and a mature economy, we believe that the Japanese will adapt to their demographic situation, but primarily through Arrows 2 and 3, which require very fundamental reforms aimed directly at Japanese society. Only by addressing its fiscal, labor, and agricultural issues, will Japan will avoid the vicious cycle of fewer births leading to fewer women of child-bearing age leading to fewer births, etc.[4] The trillion dollar question is whether Japan can enact those changes. We believe they will do so, but that more will be required beyond Arrows 2 and 3 in this pursuit.
Lastly, Japan is not alone in facing the daunting challenge of an aging and shrinking population; it is merely at the front of the line of ships of state heading into these waters. Almost all the major economies, including China, face their own population crests sometime in the next 10-20 years. Japan’s navigation of these waters will certainly provide lessons, good and bad, for those who follow in its wake. Investors would find themselves increasingly cut off from too many excellent individual investment opportunities were they to shun the stocks of nations facing Japan’s aging issues.[5]
[1] Traditional monetary policy focuses spurring economic growth by lowering the cost of money through central bank interest rate manipulation. Quantitative easing attempts to spur growth by driving down market interest rates through large central bank purchases of higher quality bonds, thus driving up bond prices and driving down bond yields. Qualitative easing attempts to drive positive growth by buying riskier assets, such as stocks and stock funds, to create a “wealth effect” by driving up equity prices and creating the perception in equity holders of greater personal wealth and, thus, greater personal spending.
[2] In the face of Japan’s depopulation problem, some of Japan’s smaller towns, which are the first to see the real effects of the birth/death imbalance, have taken to “re-populating” their empty public spaces with manikins or large dolls: http://www.dailymail.co.uk/news/article-2865345/Scarecrows-outnumber-people-dying-Japan-town.html
[3] “Monetary Policy not Accommodating Enough” does not appear in any of the Japanese marriage/family surveys in a recent Washington Post article:
[4] For example, the Japanese female participation in the workforce is amongst the lowest in the developed world at 63%. This would appear to be a promising area from which to increase the labor pool.
[5] Past performance is no guarantee of future results and there can be no assurance that the results presented herein can be achieved. Actual performance for client accounts may be materially lower than the results shown. Information provided reflects Neosho’s views as of the date of this presentation. Such views are subject to change at any point without notice. Neosho obtained some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and we are not responsible for the consequences of any decisions or actions taken as a result of information provided in this presentation and does not warrant or guarantee the accuracy or completeness of the information requested or displayed.. Information contained herein is for informational purposes only and should not be considered a recommendation to buy or sell any securities. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. Neosho has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor's financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
