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Japan’s stunning monetary experiment

12-04-2013 | News item | Léon Cornelissen The Bank of Japan’s plan to expand its balance sheet by 1% of GDP per month is a radical but risky plan, says Robeco’s Chief Economist Léon Cornelissen.

Speed read
  • Global growth continues at below-trend pace
  • Japan starts monetary revolution
  • Resilience of US recovery contrasts with weakening eurozone economy
  • Emerging debt still in favor despite faltering outlook
  • Equities have room to move higher
  • North America is preferred region within equities
  • Underperformance of emerging markets equities set to continue
  • Commodities’ prospects have deteriorated

With other regions seeing more of the same—the US recovery is maintaining its momentum and the eurozone is continuing to deteriorate—the spotlight has switched to Japan, thanks to the latest act in the implementation of Abenomics.

That’s the radical policy mix instituted by prime minister Shinzo Abe, which includes inflation targeting, negative interest rates, quantitative easing, bond buying and weakening the yen.

Despite already-heightened expectations, the Bank of Japan (BoJ) managed to surprise markets with the announcement of a monetary stimulus program that Robeco Chief Economist Léon Cornelissen describes as “stunning”.

Here’s why. The BoJ is to expand its balance sheet by 1% of GDP per month. To put that into context, that is almost double the rate of the US Federal Reserve’s intervention. The idea is to push down the yen and generate an inflation level of 2% in two years’ time.

It is a high-risk strategy. “It is nothing short of a monetary revolution, which will be closely monitored by the rest of the world,” says Cornelissen. “The main risk of this aggressive policy move is a hike in long-term interest rates.” But he believes this will probably be prevented by a combination of financial repression and BoJ buying of longer-term JGBs to keep yields down.

Still, it is early days. True, sentiment has improved and the Tokyo bourse has performed well in local-currency terms, but the Japanese economy is not yet on the road to recovery. This was illustrated by the disappointing -8 reading for the Tankan, which measures large manufacturers’ sentiment, for the January-March period.

Global economic expectations boosted by Japan moves
Mind you, increasing optimism about Japan’s prospects is one factor behind a modest, positive shift in the Financial Markets Research team’s expectations for the global economy. Although their baseline scenario remains below-trend growth, they have lowered their estimate for that scenario from 70% to 65%. That means the likelihood of a traditional recovery has risen from 15% to 20%.

One other factor contributing to that decision was the good news in the US economy. True, jobs growth fell back sharply in March. But as Cornelissen puts it, “momentum in the US economy remains positive.”

Housing market indicators are still trending upward. Unemployment continues to decline, though the latest 7.6% reading means there is still quite a way to go before the Fed’s unemployment target of 6.5% is reached. As Cornelissen points out, that suggests that the central bank’s supportive monthly Treasury purchases will only be reduced in early 2014.

Finally, investment activity that was put on ice due to the uncertainty surrounding the fiscal debate is expected to pick up, now that a deal on the US budget is in place until 30 September.

Across-the-board deterioration in the eurozone
Contrast that upbeat picture to the eurozone, where there has been bleak news from every front. On the economy, forward-looking indicators suggest that the German economy is stalling and that France is weakening.

In policymaking, the bungled Cyprus bail-out has damaged confidence again, raising the risk of renewed capital flight from the periphery.

And in politics, the electoral stalemate in Italy will probably result in more elections in July. That raises the risk of a higher risk premium on Italian government bonds if the electorate does not opt for a government willing to implement eurozone-approved austerity and reform. “The true extent of the conditionality for the ECB’s OMT program could be tested and political tensions in the eurozone could rise sharply,” warns Cornelissen.

Against this gloomy backdrop, the ECB is contemplating a modest rate cut in May. “We would not expect it to have a significant impact, as the transmission mechanism is clearly broken,” says Cornelissen.

The global macro picture in numbers

Japan’s stunning monetary experiment | IMAGE

Positive on equities
So how does this moderately improving macro picture feed through into asset-allocation positioning? Cornelissen and his colleagues remain positive on equities. Despite hiccups such as the botched Cyprus bail-out, conditions remain supportive for further equity market gains.

After all, the global economy continues to grow at a 2% pace, quantitative easing is being stepped up and earnings are stabilizing close to record-high margins. “The first two of these three factors are the dominant forces at play,” says Cornelissen. Moreover, valuation is just above neutral.

That’s not to say that risks factors are absent. A lack of support for economic reform in Italy and the eurozone’s deteriorating economic performance could hurt sentiment. But Cornelissen argues that the quantitative easing and the moderate economic growth should be strong-enough forces to ensure that the positive stock-market climate endures.

North America is preferred region in equities
Within equities, North America is the team’s favorite region. That’s mainly down to the macro situation. “The US market is expensive,” concedes Cornelissen, “but other regions offer a less-attractive economic outlook.”

Consider Europe. The eurozone debt crisis continues. Industrial production and retail sales are falling. Moreover, no positive surprises should be expected: Slovenia and Malta appear to be heading into the arms of the Troika, fresh elections loom in Italy and the budget-deficit targets for Spain and France look ambitious, given the countries’ poor data. “We expect a relatively weak performance from European equities,” says Cornelissen.

“We expect riskier assets to outperform government bonds”

Economic data in emerging markets has been on the weak side and most currencies have come under some pressure. In addition, equity market momentum is weak. “The outlook is deteriorating and, as a result, we expect the underperformance to continue,” says Cornelissen.

Prospects for Pacific have improved
By contrast, the outlook for the Pacific is improving, as the weakening yen should boost Japanese exports. Again, though, the team maintains its neutral view on the region. “We want to see more economic proof that Abenomics will benefit Japan,” says Cornelissen.

High yield and emerging markets favored
The team continues to like the prospects for corporate bonds, both credits and high yield. “High yield has the best prospects, thanks to running yields that still offer decent absolute returns in the current low-interest-rate environment,” says Cornelissen. While he cautions that “companies are becoming less bondholder friendly,” he adds this is not yet a cause for major worries.

Emerging markets debt also remains in favor. The asset category is experiencing solid net inflows, albeit at a slower pace than previously. Yet some less encouraging signals are appearing; current account balances and government budget balances in emerging markets are deteriorating against the backdrop of the disappointingly slow global recovery.

“Although some gloss has come off emerging markets economies, we remain positive on emerging market debt relative to developed government debt,” says Cornelissen.

Negative on government bonds
The team maintains a negative view on government bonds. Although Cornelissen and colleagues do not expect a significant rise in yields, this continues to be the least attractive asset category. As inflation expectations are well anchored and central banks continue their buying, rates are tending to stay too low.

“This is positive for bond investors but these low yields do not offer the opportunity for decent returns,” he says. “We expect riskier assets to outperform government bonds.”

Real estate prospects attractive despite valuation
The outlook for real estate remains good: the team ranks its prospects in line with those of equities. Thanks to low interest rates and a stock-market rally that is benefiting defensive sectors, real estate’s returns continue to be satisfactory. Moreover, the earnings outlook is more realistic for real estate than for equities. Only an overvaluation of 15% or more versus equities holds the team back from positioning real estate above equities.

Slightly negative on commodities
Finally, a change in the outlook for commodities, which has been shifted from neutral to slightly negative. For one thing, demand for oil in the medium term is set to be lower, thanks to China’s more-modest growth trajectory, the ongoing deterioration in eurozone economic activity and the slower expansion of emerging economies.

Second, gold has lost its momentum. Lower inflation expectations in the US, decreased physical demand and reduced central bank hoarding of gold continue to put downward pressure on prices. “We feel that only a significant geopolitical risk event or a sudden growth slowdown in the US would see gold prices trend upwards again,” says Cornelissen.

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