A new economic dawn in Japan could spell trouble for the West

Investors are beginning to ask whether a new economic dawn is breaking in the Land of the Rising Sun. Japan – for decades a watchword for the dangers of price deflation and a falling population – is gearing up to raise interest rates for the first time in seventeen years. Japan’s major stock market index, the Nikkei 225, recently breached its all-time high last set in late 1989. The fact it took thirty-five years to break this threshold illustrates just how big the 1980s stock market bubble became – particularly in Japanese property. But also how sustained has been the correction. As investors fret over the impact of higher interest rates on western commercial property, it is an instructive warning on how protracted a stock market crash can be.

Japan’s potential economic rebound is generating excitement about what is still – for all its recent challenges – the world’s fourth largest economy. Investors anxious about debt levels in the US, heavy political oversight in China, and a recession in Germany are considering whether an old friend requires a fresh look. The Nikkei having smashed through that 1989 record, is up almost 20% since the start of the year.

Japanese assets have long appealed to investors because of the diversification of Japanese companies – as well as economic and societal trends – from those facing western companies. Many of the smartest investors I speak to fear quite how correlated and dominant US dollar assets are becoming in pension and savings portfolios. This presents a huge challenge in avoiding high volatility – and high losses – should sentiment towards the worlds pre-eminent reserve currency begin to shift. Statistically speaking Japanese assets have been the most effective hedge to this Dollar concentration risk over the last decade. This is an attractive trait. However to get this exposure international investors have had to accept very low, even negative interest rates, as the Bank of Japan has indulged in the most extraordinary policy experiment to purchase assets and control interest rates.

The near permanent risk for investors in recent years has been that the Japanese government and central bank coordinate to devalue the Yen and reduce the domestic value of these Japanese investments. Whilst almost all major currencies have softened against the Dollar in the last decade, the Yen has lost almost half its value as the Bank of Japan persisted the longest and went the furthest with negative interest rates. This is a policy they retain to this day. If this backdrop is poised to change you can imagine the scale of pent-up demand that could flood back into a Japanese stock market worth 6.5 trillion dollars. Markets are currently seeing it as a coin toss on whether the Bank of Japan raise their headline interest rate from -0.1% at their March policy meeting.

So what are the signs of a breakout of higher inflation in Japan? Like all major economies, Japan has experienced energy and food price inflation in recent years – albeit at more subdued levels. In the last three years Japanese prices have risen 7%. It took thirty-one years for prices to rise the previous 7%! But this was never going to be enough until it showed signs of spreading to wages and services prices. This is now starting to happen with Rengo, Japan’s largest trade union, recently reporting wage demands hitting 5.85%. More anecdotally a colleague of mine who is regular visitor to Japan has reported the hotel he stays at has just raised prices for the first time in twelve years. These are the signs of a broad and sustained increase in prices that may encourage the BoJ to leave its emergency policy setting.

So far, so exciting. However for those of a more nervous disposition there is concern that a potential exit from decades of extraordinary macroeconomic policy could unearth some significant stresses. If this happens it is unlikely to remain confined to Japan. There are global ramifications, including for the UK. 

Faced by decades of low and negative interest rates Japanese savers have responded by buying large quantities of foreign debt that yield higher interest rates and act as a hedge against a weak Yen. While financial markets and economists focus intensely on China as a key holder of US debt, Japan’s holdings are even more material. The latest data from the US Treasury suggest that Japanese institutions hold more US federal debt than any other country at more than $1.1trillion. Should the Japanese economy move to being more favourable for investment then it is plausible that this debt begins to be sold with big implications for a US economy running huge deficits under both the Biden and Trump administrations. Higher interest rates to attract buyers for the US debt pile has uncomfortable implications for household and company interest rates around the world.   

This year, investors and households sensitive to higher interest rates seem to have absorbed the news that interest rates won’t be coming down as quickly as had been widely foreseen. That is encouraging. But this has largely been the function of reassuring data on the strength of the US economy and a further decline in European energy costs. It would be a very different test of nerve should one of the largest financiers of very low borrowing costs pulls its funding from global markets.

Seasoned Japan watchers will note we have been here before. The demographics for Japan remain precarious. The population is expected to fall a further 17% by 2050 to leave it 23 million below its peak. The birth rate in 2023 was the lowest since records began in the nineteenth century. Whilst net migration had been picking up prior to the COVID pandemic it remained at very low levels by international standards. This demographic backdrop has been deflationary, and may yet reassert itself. And whilst there is a respectable case that a shortage of workers can eventually be inflationary, this has not been the evidence from Japan in recent decades – so much so that “Japanification” became its own word in economic literature. Japanification may be on the cusp of entering a new chapter. The rest of the world should take note.

Published on The Times 11/03/2024