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Japan Offers Lessons For Investors About Deflation
Policy decisions by central banks – such as an accommodative monetary policy which is designed to stimulate economic growth by lowering short-term interest rates to make borrowing money less expensive – has been driving capital markets since the Great Recession. While loose credit has been sufficient to cushion and stabilize the global economy through various shocks, it has not been enough to push the global economy off of its low inflation, low growth equilibrium because fiscal policy in Europe and the U.S. has been too tight. Consider the consequences. The U.S. economy is in its seventh year of recovery since the Great Recession, but global GDP growth remains well below pre-crisis levels. Most developed nations also continue to experience inflation that is below central bank targets of 2%. Looking at the whole investment picture, we believe that deflation presents a graver risk than inflation, and fiscal and monetary coordination will be required to reignite global growth. And Japan may show us the way out.
Japan was first to fall into this no inflation equilibrium, which it is now tackling with aggressive policy measures. After the bursting of its real estate and stock market bubble in the late 1980s, Japan experienced a “lost decade” with a growth rate per capita of 0.5% from 1991 to 2000. Deflation first appeared in 1995 and became structurally endemic from 1999 onward.
Like much of the developed world, Japan faces demographic challenges. Japan’s working age population peaked around 1990 and the absolute population began to decline in 2007. Labor is a key input for economic growth since declining population drags down growth and consumption. Japan first saw the yield of the 10-year bond dip below 1% in late 2011 with yields dropping below 0% earlier this year. The German bond 10-year yield dipped below 1% in 2014 and is currently at 0%. In the U.S., the 10-year bond yield is currently at 1.6%. The potential growth rate for the U.S. remains higher than either Europe or Japan because the U.S. faces a slowdown, not a decline, in the growth of the working age population.
Japan leading the way
The market has been consistently too ready to forecast rate hikes despite this deflationary risk.
Japan has been a pioneer in fighting deflation. Earlier this year, the Bank of Japan was the first to initiate quantitative easing (buying government securities to lower interest rates and increase the supply of money), the first to implement negative rates (to encourage commercial banks to lend more money instead of keeping unused “penalized” cash at the central bank), and the first to cap the government 10-year yield at 0%. On September 21, 2016, the Bank of Japan added another first when it explicitly pledged to overshoot its 2% inflation target. Japan’s central bank also recently touted the “synergistic effect” between monetary and fiscal policies, which could mean the country is moving a step closer to explicit monetary financing or “helicopter money,” which is an aggressive form of stimulus (the government literally prints more money) to spur growth and increase inflation.
While Japan’s extreme deflation busting tactics have not yet achieved their goals, other central banks may need to follow their lead. The Federal Reserve had a cap on long-term yields in the 1940s as part of an effort to keep down wartime and postwar debt financing, and Federal Reserve Bank of Chicago President Charles Evans has floated the idea of overshooting the U.S inflation target.
In a bit of déjà vu, U.S. monetary policy seems to be exactly where Japan was a decade ago. The U.S. has ended quantitative easing programs and the Federal Reserve raised interest rates at the end of last year. The Fed seems poised for an additional rate hike at the end of this year. Just as Japan had to quickly cut rates back to zero and resume monetary easing after the 2008 financial crisis, we expect that the Fed will be forced to quickly reverse any tightening, and likely take additional easing measures, when the U.S. economy inevitably encounters setbacks in the future.
As Japan’s ambitious monetary and fiscal strategies play out, it will provide a road map for the U.S. and European monetary policy of the future. Until then, investors should be more concerned about deflation than inflation, and should also be aware of the profound effect that currency movements can have on their portfolio returns. Some family offices have pursued a strategy of buying Japanese stocks but hedging their exposure to the yen. More broadly, investors should watch for a more positive turn in global fiscal and monetary policy as a signal to add to risk in their portfolios. Conversely, if the U.S. and other developed economies repeat some of Japan’s early mistakes of stop-and-go policy, this will likely dampen economic growth and asset returns.
