Inflation in Japan: threat or opportunity?
Inflation in Japan: threat or opportunity?
Dan Carter and Mitesh Patel examine a surprising move from the Bank of Japan – was it a mistake, and what consequences might it have for the Japanese equity market?
Who, or rather what, is Kazuo Ueda? A policy genius, delicately balancing the many needs and wants of the Japanese economy? Or a choker overwhelmed by the job nobody else wanted – as Governor of the Bank of Japan – who has fluffed his big moment? History will decide, but the July decision by the BoJ to tweak its yield curve control policy has investors wondering. Wondering why such a tweak was made, and what it might mean for monetary conditions from here. Wondering how this could affect the equity market and which stocks might be the biggest winners and losers. This piece takes a closer look at these questions.
What has the Bank of Japan done, and why?
Until July, BoJ policy had been to forcibly contain the yield on 10-year Japanese government debt to a range of 0.5% above or below zero. To keep yields in check as persistent global inflation led other central banks to hike rates, the Bank of Japan was forced to buy its own government debt in size – to the tune of almost 16% of GDP in the eight months to July. With well over half of all JGBs held by the Bank of Japan, the very idea of there being a market for JGBs was being called into question.1 At its July meeting, the BoJ said it would continue to allow 10-year Japanese government bond yields to fluctuate in the previous range around zero, but crucially that it would purchase 10-year JGBs with yields of 1% through fixed-rate operations. In theory this adds an additional 50 basis points to the permitted yield range, although exactly in what circumstances the BoJ might intervene if yields are between 0.5%-1.0% remains unclear.
What might the Bank of Japan do from here?
Ueda’s critics wail that this injection of ‘will he, won’t he?’ uncertainty about intervention in the 0.5% and 1% yield range is unhelpful. At best it shows indecision, they say, while at worst it is a sign that Ueda – who has spoken before about the importance of clear guidance – speaks with a forked tongue.2 To us, this seems harsh.
It has long been our hunch that the Bank of Japan would tread the line of monetary normalisation very carefully. As a mature economy with an increasingly mature population, consumption is fragile and trend economic growth moderate at best. No central banker wants to crash their economy, but it is understandable that the Japanese seem particularly sensitive to the risk. Inflation, though high in a Japanese context is unexceptional when compared to other developed markets, at least at their peaks. Deflation – which the Bank fought so hard to escape – is a recent memory in Japan, so nobody should be surprised that its central bankers are unenthusiastic inflation fighters.
In that context, it is surely relevant that the BoJ’s official inflation forecasts now show a return to the 2% target by 2024 and dipping below it thereafter. Just how literally this should be taken is debatable, however. 3
With almost ¥1 quadrillion ($13tn) of outstanding debt – some 260% of GDP – the Japanese government is surely reluctant to see bond yields move too far or fast. This year, debt servicing will eat up 22% of the government’s ¥114tn ($800bn) national budget.4 Ueda will receive little thanks from the Prime Minister’s office if he invites more financial stress or imperils the country’s single-A credit rating.
It seems more likely that the Bank of Japan sees inflation not as a threat, but an opportunity – one to curtail its distortions on the bond market; to normalise policy. A milquetoast approach to some looks more like delicate pragmatism to us.
It has long been our hunch that the Bank of Japan would tread the line of monetary normalisation very carefully. As a mature economy with an increasingly mature population, consumption is fragile and trend economic growth moderate at best. No central banker wants to crash their economy, but it is understandable that the Japanese seem particularly sensitive to the risk. Inflation, though high in a Japanese context is unexceptional when compared to other developed markets, at least at their peaks. Deflation – which the Bank fought so hard to escape – is a recent memory in Japan, so nobody should be surprised that its central bankers are unenthusiastic inflation fighters.
In that context, it is surely relevant that the BoJ’s official inflation forecasts now show a return to the 2% target by 2024 and dipping below it thereafter. Just how literally this should be taken is debatable, however. 3
With almost ¥1 quadrillion ($13tn) of outstanding debt – some 260% of GDP – the Japanese government is surely reluctant to see bond yields move too far or fast. This year, debt servicing will eat up 22% of the government’s ¥114tn ($800bn) national budget.4 Ueda will receive little thanks from the Prime Minister’s office if he invites more financial stress or imperils the country’s single-A credit rating.
It seems more likely that the Bank of Japan sees inflation not as a threat, but an opportunity – one to curtail its distortions on the bond market; to normalise policy. A milquetoast approach to some looks more like delicate pragmatism to us.
Is this good or bad for Japanese equities?
That the valence of the equity market’s reaction to monetary tightening is in question is telling of the perversity of modern economic conditions. Textbooks tell us that rising interest rates should push down the value of stocks. As perpetual securities, the value of their future cashflows need to be more heavily discounted. Simultaneously, higher returns for risk free assets like government debt mean that risky assets like equities must offer even higher future returns, something that can be achieved only by a lower starting price. This time, though, there are hopes that tighter monetary conditions might be good for companies’ share prices contrary to financial orthodoxy.
This hope is founded partly upon recent history. In 2016, the Bank of Japan adopted negative interest rates, intending to inject some vim into the market and the economy. In the event, the equity market slumped, confounding the policymakers. 5 So radical was the move that it was taken as a sign of desperation, an indication that Japan’s economic straits were worse than many had thought. It also mounted yet more pressure on the beleaguered banks, a strategically important sector which needs to be sufficiently healthy for everyone’s benefit. If the current situation is akin to the opposite of 2016 – i.e. the economy is sufficiently robust to tolerate higher rates, financial distortions are ironed out and pressure on the banks is relieved – then perhaps the equity market’s reaction will be the opposite too.
A further argument goes that higher government bond yields will act as a general Japanese magnet for international capital, and that some of this will spill over into the equity market. Domestic money deployed overseas might similarly be spread across a range of Japanese assets when repatriated. Maybe, but this looks more like hope than expectation.
A final argument is one simply of market composition; that Japan is richer in the kind of companies which might benefit from higher rates than it is in those which might be expected to suffer. Jupiter’s risk model – driven by historical correlations – suggests that an upward shock to JGB yields should boost Topix, led by banks but supported by life companies and other financials as well as trading companies and auto sectors. 6
The bear case rests mainly upon the financial orthodoxy mentioned above. Most meaningful is the concern that higher yields on government debt might arrest the flow of household assets into equities or reverse it. The problem with this is that there has been no meaningful flow of household assets between JGBs (or cash and deposits) and equities in either direction for years, despite significant changes in inflation and both nominal and real yields.7 It seems a leap to presume that this will begin now. Overall, then, in our eyes the bulls seem to tip the scales with the weight of their arguments.
This hope is founded partly upon recent history. In 2016, the Bank of Japan adopted negative interest rates, intending to inject some vim into the market and the economy. In the event, the equity market slumped, confounding the policymakers. 5 So radical was the move that it was taken as a sign of desperation, an indication that Japan’s economic straits were worse than many had thought. It also mounted yet more pressure on the beleaguered banks, a strategically important sector which needs to be sufficiently healthy for everyone’s benefit. If the current situation is akin to the opposite of 2016 – i.e. the economy is sufficiently robust to tolerate higher rates, financial distortions are ironed out and pressure on the banks is relieved – then perhaps the equity market’s reaction will be the opposite too.
A further argument goes that higher government bond yields will act as a general Japanese magnet for international capital, and that some of this will spill over into the equity market. Domestic money deployed overseas might similarly be spread across a range of Japanese assets when repatriated. Maybe, but this looks more like hope than expectation.
A final argument is one simply of market composition; that Japan is richer in the kind of companies which might benefit from higher rates than it is in those which might be expected to suffer. Jupiter’s risk model – driven by historical correlations – suggests that an upward shock to JGB yields should boost Topix, led by banks but supported by life companies and other financials as well as trading companies and auto sectors. 6
The bear case rests mainly upon the financial orthodoxy mentioned above. Most meaningful is the concern that higher yields on government debt might arrest the flow of household assets into equities or reverse it. The problem with this is that there has been no meaningful flow of household assets between JGBs (or cash and deposits) and equities in either direction for years, despite significant changes in inflation and both nominal and real yields.7 It seems a leap to presume that this will begin now. Overall, then, in our eyes the bulls seem to tip the scales with the weight of their arguments.
Which sectors win/lose with higher rates?
If the pace, method and extent of policy normalisation is put aside, and some level of monetary tightening is presumed, it makes sense to ask which companies and sectors might benefit or suffer the most. The risk model mentioned above clearly highlights financials – when ranked by observed historical sensitivity to 10-year JGB yields, banks occupy all but eight of the top fifty positions.8 This makes sense – the spread between interest on loans and deposits has been crushed in recent years, so any alleviation of that would be extremely welcome.
Despite the temptation, investors should think carefully before piling into the Japanese banking sector, not least because of the very statistic mentioned above. That Japan even has forty-two banks to populate the top fifty most sensitive listed companies (indeed it has many more, of the hundred most sensitive stocks, seventy-two of them are banks) is evidence of just how overbanked the country is.9
Even when money was free, loan growth was meagre – and slower than deposit growth – so a higher cost of money seems unlikely to boost it. Our position is to hold a small overweight in the banking sector, whilst avoiding the most challenged regional banks entirely. The rationale here is that we wish to balance the pros of interest rate sensitivity, low valuations and high yields with the structural challenges the sector has long faced.
At the other end of the sensitivity spectrum, populated by companies which have historically seen their share prices fall when rates rise, we see a mixed bag of sectors with common characteristics. Richly valued, asset light, growth companies dominate this end of the list. Again, this makes sense; if a business relies heavily for its value upon potential earnings far in the future rather than the near term or the liquidation value of its assets, then the rate at which those earnings are discounted will affect value greatly. With global rates having been on the up for some time, the equity market has had some time to think about this. It seems to us that the market has gone a very long way to incorporating this into valuations; over the last two years, the Topix Value index is up 40%, while Topix Growth is up only 10%.10
Still, for investors like us who aim to include a premium of earnings growth in their portfolios, this could be a headwind. However, this serves only to raise the bar in stock selection – if fair values are to be squeezed on monetary conditions, then the shares had better be bought well below that fair value no matter what the growth profile. This is what we aim to do.
Finally, those businesses carrying the most debt could be in for a much tougher time if funding costs are allowed to rise. This might seem obvious, but it is a fact which has been easy to forget with interest rates at rock bottom. At the sector level, electric power companies are most at risk; Tohoku Electric Power has almost ¥3tn of net debt on ¥630bn of equity, resulting in interest costs which ate up all of last year’s earnings before interest, tax, depreciation and amortisation and then some. Chugoku, Tokyo, and Kyushu electric power companies are slightly less stressed, but still rank highly amongst Japanese corporates when listed by proportion of profits paid away in interest expense. Elsewhere, funding stress is a company rather than sector specific phenomenon so stock selection will be key. Of Japan’s best known large caps, Softbank Group stands out with two thirds of last year’s EBITDA used to pay interest.11,12 Masayoshi Son will be hoping that a smooth exit from British chip design company ARM will allow the company some breathing space.
Despite the temptation, investors should think carefully before piling into the Japanese banking sector, not least because of the very statistic mentioned above. That Japan even has forty-two banks to populate the top fifty most sensitive listed companies (indeed it has many more, of the hundred most sensitive stocks, seventy-two of them are banks) is evidence of just how overbanked the country is.9
Even when money was free, loan growth was meagre – and slower than deposit growth – so a higher cost of money seems unlikely to boost it. Our position is to hold a small overweight in the banking sector, whilst avoiding the most challenged regional banks entirely. The rationale here is that we wish to balance the pros of interest rate sensitivity, low valuations and high yields with the structural challenges the sector has long faced.
At the other end of the sensitivity spectrum, populated by companies which have historically seen their share prices fall when rates rise, we see a mixed bag of sectors with common characteristics. Richly valued, asset light, growth companies dominate this end of the list. Again, this makes sense; if a business relies heavily for its value upon potential earnings far in the future rather than the near term or the liquidation value of its assets, then the rate at which those earnings are discounted will affect value greatly. With global rates having been on the up for some time, the equity market has had some time to think about this. It seems to us that the market has gone a very long way to incorporating this into valuations; over the last two years, the Topix Value index is up 40%, while Topix Growth is up only 10%.10
Still, for investors like us who aim to include a premium of earnings growth in their portfolios, this could be a headwind. However, this serves only to raise the bar in stock selection – if fair values are to be squeezed on monetary conditions, then the shares had better be bought well below that fair value no matter what the growth profile. This is what we aim to do.
Finally, those businesses carrying the most debt could be in for a much tougher time if funding costs are allowed to rise. This might seem obvious, but it is a fact which has been easy to forget with interest rates at rock bottom. At the sector level, electric power companies are most at risk; Tohoku Electric Power has almost ¥3tn of net debt on ¥630bn of equity, resulting in interest costs which ate up all of last year’s earnings before interest, tax, depreciation and amortisation and then some. Chugoku, Tokyo, and Kyushu electric power companies are slightly less stressed, but still rank highly amongst Japanese corporates when listed by proportion of profits paid away in interest expense. Elsewhere, funding stress is a company rather than sector specific phenomenon so stock selection will be key. Of Japan’s best known large caps, Softbank Group stands out with two thirds of last year’s EBITDA used to pay interest.11,12 Masayoshi Son will be hoping that a smooth exit from British chip design company ARM will allow the company some breathing space.
A future of ‘measured normalisation’?
To us, the Bank of Japan’s policy tweak seems sensible and well-thought out rather than a policy blooper. We have little foresight of BoJ action from here, but the moderate nature of the recent move did not surprise us and so further measured normalisation seems most likely. That said, shocks in either direction are possible and so our positioning is designed to minimise monetary conditions as a factor, rather than to play them. Consensus has coalesced around some kind of normalisation though, and this is probably a good thing.
When the Bank of Japan pushed too far into abnormality early in 2016 it was taken badly, and so a gradual shift more a regular monetary regime should be seen as a vote of confidence and could be good rather than bad for stocks. Banks are the obvious beneficiaries of higher rates, but investors should beware not to get carried away – the sector has some problems which will not be fixed by the central bank. Gearing too should be on investors’ minds – low rates and minimal levels of overall net debt have been a feature of Japan, but there are pockets of potential stress which would be wise to be avoided.
When the Bank of Japan pushed too far into abnormality early in 2016 it was taken badly, and so a gradual shift more a regular monetary regime should be seen as a vote of confidence and could be good rather than bad for stocks. Banks are the obvious beneficiaries of higher rates, but investors should beware not to get carried away – the sector has some problems which will not be fixed by the central bank. Gearing too should be on investors’ minds – low rates and minimal levels of overall net debt have been a feature of Japan, but there are pockets of potential stress which would be wise to be avoided.
1 N Smith, Benthos, BoJ: why hike and what to buy, July 2023
2 At time of writing, the BoJ has already conducted unscheduled buying on more than one occasion
3 Bank of Japan, Outlook for Economic Activity and Prices (July 2023) (boj.or.jp)
4 Bloomberg, Japan’s Fiscal Plight Draws Scrutiny after BoJ Tweak to YCC
5 We were amongst those London based investors asked by the vexed central bankers to explain the market’s apparently perverse reaction
6 Jupiter, August 2023
7 M Kikuchi, Mizuho Securities, August 2023
8 Jupiter, August 2023
9 N Smith, Benthos, BoJ: why hike and what to buy, July 2023
1o Total return, Bloomberg, August 2023
11 The Jupiter Japan funds hold shares in Softbank Corp, the listed subsidiary of Softbank Group, not in the parent
12 Bloomberg, August 2023
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