Richard Koo of Nomura is out with his latest report. The report discusses in length the reasons for the recent decline and volatility of the Japanese stock market. Richard Koo is skeptical of Abenomics as we pointed out in his late research note in which he stated Japan’s Tactic Of Lying ‘Has Succeeded Brilliantly’. Below is the full report from Richard Koo.
Richard Koo on Japan Market Decline
Stock markets around the world have undergone a correction over the past two weeks, but Japanese equities experienced by far the sharpest hit. The yen also strengthened to some extent against other currencies, signaling a possible end to the trend of a weak yen and a rising stock market.
Reasons cited for the equity selloff include Fed Chairman Ben Bernanke’s remarks about ending quantitative easing and a weaker than expected (preliminary) Chinese PMI reading from HSBC Holdings plc (NYSE:HBC) (LON:HSBA) on 23 May. However, I think a more fundamental factor was also involved: stocks had risen far above the level justified by improvements in the real economy. The yen’s decline and the stock market gains that followed the announcement of Abenomics at the end of last year clearly outpaced the economic recovery.
The prevailing view is that we are finally seeing a reaction to this excessively rapid move, and if so this is a healthy correction. The reality, however, may be somewhat more complicated.
Richard Koo: Divergence in investor behavior fueled virtuous cycle of lower yen and higher stocks
More specifically, the sharp rise in equities that lasted from late in 2012 until a few weeks ago and the several virtuous cycles that fueled this trend were themselves made possible by a special set of circumstances.
Whereas overseas investors responded to Abenomics by selling the yen and buying Japanese stocks, Japanese institutional investors initially refused to join in, choosing instead to stay in the bond market.
Because of that decision, long-term interest rates did not rise. That reassured investors inside and outside Japan who were selling the yen and buying Japanese equities, giving added impetus to the trend.
Richard Koo: Japanese institutional investors understand private demand for funds is negligible
The next question is why domestic and overseas investors responded so differently to Abenomics. One answer is that many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies—should be effective.
Short-term rates in Japan have been at or near zero since around 1995, some 18 years ago. The BOJ engaged in an aggressive quantitative easing initiative from 2001 to 2006, under which it supplied more than ¥30trn in excess reserves at a time when statutory reserves amounted to just ¥5trn. Yet neither the economy nor asset prices reacted meaningfully.
In the last few years, Japanese corporate balance sheets have grown much healthier and interest rates have remained at historic lows. Yet private demand for funds did not recover because 1) firms were still in the grip of a debt trauma and 2) there was a shortage of domestic investment opportunities.
Japan’s institutional investors were painfully aware of this reality, which had left them facing a lack of domestic investment opportunities for more than a decade. From their perspective, there was no reason to expect another foray into quantitative easing by the BOJ under pressure from the Abe administration to lift the economy, and therefore no reason to change their behavior.
Richard Koo: But overseas investors bet on bold monetary easing
Meanwhile, overseas—and particularly US—hedge funds that had been betting on a worsening of the euro crisis until last autumn were ultimately unable to profit from those positions because the euro did not collapse.
Then in late last year, the Abe government announced that aggressive monetary accommodation would be one of the pillars of its three-pronged economic policy. Overseas investors responded by closing out their positions in the euro and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher.
I suspect that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible. Had they understood this, they would not have behaved in the way they did.
Richard Koo: Bond and equity markets took very different views of Japan’s economy
The yen weakness and stock market appreciation brought about by this money began to buoy sentiment within Japan, paving the way for further gains in equities. They also prompted retail investors to enter the market, providing more fuel for the virtuous cycle.
Japanese equities were up 80% from their lows at one point. However, this virtuous cycle was based on the key assumption that interest rates—and long-term interest rates in particular—would not rise.
This condition was satisfied as long as domestic institutional investors remained in the JGB market, but consequently the views of the Japanese economy held by equity and bond market participants diverged substantially.
Moreover, even though the moves in the equity and forex markets were led by overseas investors with little knowledge of Japan, the resulting improvement in sentiment and the extensive media coverage of inflation prospects forced domestic institutional investors to begin selling their bonds as a hedge.
Richard Koo: Honeymoon for Abenomics finally ends
The result was a correction in the JGB market from mid-April onwards, with the ensuing turmoil prompting a correction in equities as well.
In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher. This means further gains in equities will require stronger corporate earnings and a recovery in the economy.
Richard Koo: Yen weakness likely to persist on trade deficits
The share price increases driven by the prospect of improved corporate earnings due to the weaker yen will probably persist going forward. Now that Japan is running trade deficits, the yen is unlikely to see the kind of appreciation observed in the past.
Naturally, exchange rates are relative things, and the yen might well rise back into the 90–100 range against the US dollar depending on conditions in the US economy. But I do not expect USD/JPY to return to the area below the mid-80s.
The yen’s decline to around 100 against USD has definitely been a positive for the Japanese economy. But authorities will need to tread carefully when dealing with additional yen weakness, including the question of what might stop the yen from falling further. Excessive drops in the currency could spark a “sell Japan” movement like that seen in 1997, when investors simultaneously sold off the yen, Japanese stocks, and Japanese bonds.
In addition, the