Two important macro developments last week were; 1) the change in the Fed’s mandate away from the Volker-era fear of inflation to the current fear of deflation; and 2) the end of Abe-san’s leadership in Japan. The latter is important because the perceived failure of Abenomics outside of Japan was its inability to generate inflation. The big picture question for the Fed and other global central banks is whether the inflation target will remain elusive elsewhere and the implication that might have for asset prices. As an aside, stock prices rose 90% over Abe’s term as premier.
From our perch Japan provides a perfect example of how fiscal policy was used through the last cycle. Policymakers were willing to run large deficits during the 2008/9 crisis, but soon after the expansion started the switch was flipped back to austerity. That austerity contributed to a secondary recession in 2012. As we have noted before it is the change in the fiscal impulse (deficit) that contributes to growth. A reduction in the budget deficit reduces the fiscal contribution to GDP (chart 1). Similar to the last global recession budget deficits have expanded in this episode. However, the key to sustaining growth will be sustaining the fiscal expansion accommodated by central banks leading to higher nominal growth than post 2008.
The problem for Japan and Abenomics after 2012 was that aggressive monetary policy (negative rates and QE) was balanced by tight fiscal policy. As we often noted at the time, the Japanese government imposed a sales tax increase that was counterproductive to accommodative monetary policy. There has also been considerable debate about whether a 2% target was desirable in the first place given the economy’s stage of development and potential growth.
Beyond sustained aggressive fiscal policy backstopped by monetary policy, the key to achieving higher consumer price inflation will be a reduction in excess capacity. While the relationship between unemployment and inflation is weak from an empirical perspective, there is enough evidence to suggest that inflation will respond – with a two to three quarter lag. In the last three recessions, core consumer price inflation continued to fall, while ever the unemployment rate was higher than year ago levels.
From a timing standpoint in the current cycle, that suggests core inflation should continue to remain modest and below targets acceptable to policymakers and not disruptive to financial markets for at least another two quarters. A tactical risk for markets would be premature fiscal tightening say as a result of political gridlock in the United States or elsewhere. The good news is that there appears to be greater acceptance of sustained aggressive fiscal policy backed by monetary policy or that monetary policy alone cannot achieve a durable expansion.
The legacy of the Abe administration will not be inflation in a consumer price inflation. However, there has been a genuine improvement in corporate performance over the past decade. Japan’s equity market and profits are highly cyclical as the equity market has the highest operating leverage to global growth in the world. On the positive side, Japan’s return on equity has materially closed the gap with the global equities. In part that is likely due to greater focus on shareholder returns or reform. It is also likely due to depreciation of the yen in trade weighted terms over the period. The critical point about operating leverage is that it works both ways. Japanese equities will be high beta exposure on the global recovery when that gets going.
The final point to note is that the market has primarily been driven by valuation, rather than corporate performance over the past few decades. Even in 1995, MSCI Japan traded at a premium to global equities. However, the market now trades at a 50% valuation discount with strong free cash flow and operating leverage to a global recovery. We will use any correction over the coming weeks to scale up exposure to a high quality basket of Japanese companies.