Japan – is it finally hitting the right notes?

This article was written by Stuart Dickson and originally published by Adam & Company.

At CGWM we continually monitor economic events and how they will affect the asset allocation within our client portfolios. We are currently closely watching Japan, who have finally succumbed to increasing interest rates, initiating a probable rise in inflation. But how might this affect the value of the yen and what impact could this have on the global economy?

The recent passing of Japanese inventor Shigeichi Negishi was a reminder of just how innovative Japan has been. As described in the book ‘Pure Invention’, Negishi-san was teased about his poor singing by workers in his electronics plant in 1967. Assuming that he would sound better backed by music, he put together a tape player and a microphone and described his new product as being ‘karaoke’ or ‘empty orchestra’. The addition of a coin slot to his Sparko-Box product, so bars could charge customers, started an industry which is now thought to generate revenues of $5bn per annum.

And this is of course far from all. While a survey by the Fuji Research Group suggested the Walkman, the cup noodle, and their video games rivalled karaoke for global significance, Japan has also been ahead of the times when it comes to economics and central banking.

The deflation of the bubble economy of the 1980s, and subsequent collapse of their banking system, ushered in innovations such as quantitative easing (QE) and zero (and then negative) interest rates in an attempt to boost growth, a decade or more before they arrived in the west. And now the Bank of Japan (BoJ) has just raised rates for the first time in 17 years which is a major statement and signpost in the country’s emergence from deflation.

Why have the Bank of Japan finally raised interest rates?

The BoJ was running the last negative interest rate regime in the world and felt able to end it because the country is one of the few which actually wanted and needed some inflation, having been trapped in a deflationary spiral for the better part of three decades. Consumers and businesses were reluctant to spend and invest as prices kept falling.

The BoJ now feels comfortable lifting interest rates as the economy seems on a firmer footing and the outlook for wage growth is quite strong, pointing to further inflation ahead, These factors should enable them to hit their 2% target. The hope from here is that, with some inflation and a return of confidence in the economic outlook, the Japanese will take their cash from under their futons and spend or invest it, creating a virtuous cycle.

This hope has been music to the ears of investors as the stock market has risen 300% in the 12 years since the now late Prime Minister Abe launched a programme of economic reforms and government spending, designed to crack deflation and lift the moribund economy. The Nikkei index has just broken through its all-time high, previously set in December 1989.

Part of Abe’s plans were specifically designed to weaken the yen, thereby helping their competitiveness relative to rivals such as South Korea, China, and Germany; boosting profit growth at the big exporting companies; and lifting inflation. Japan’s largest company, Toyota Motor, has experienced a sharp increase in share price as its hybrid cars remain very much in fashion  and a weak yen has boosted the value of its sales in dollars and euros when brought back to Japan.

Will the yen cause problem for investors?

However, the weakness of the yen is also a problem for would-be investors – while the Nikkei has risen strongly, returns to overseas investors are 50% lower than they might first appear as the currency has halved in value due to the ultra-low interest rate policy.

Although Japan does not have the Artificial Intelligence (AI) companies which are powering the current US market, it does have indirect beneficiaries. From semiconductor production equipment manufacturers, which make the AI chips machines, to robotics and sensor companies, which are becoming hugely important in raising productivity in manufacturing and are also thought to benefit from the addition of AI software and chips. 

How will these changes affect our client portfolios?

We will likely maintain some exposure to the country, however the risks around currency, and the small weighting of the stock market in global benchmarks, mean it is unlikely to become a large part of client portfolios any time soon. 

While it seems unlikely at this stage, if inflation really does take hold and the BoJ raises rates faster than expectations, the Japanese bond market could become destabilised given the huge amount of debt accumulated by the government. This has the potential to threaten other markets, given investors have been borrowing cheaply in yen for decades to buy higher yielding assets elsewhere. Finally, much higher rates at home could tempt the Japanese to repatriate their cash resulting in a jump in the yen value and a slump in the profits at the big exporters which have driven the stock market higher.

We continue to monitor these risks and opportunities but at least for now events in Japan are finally hitting the right notes.

If you want to find out more, get in touch…

If you have any questions about the topics raised in this article or about investment management more generally, please speak to your dedicated Investment Manager who will be happy to talk you through it.

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