28th May 2013
J.P. Morgan’s global strategist Dan Morris considers the current state of markets and the key problems quantitative easing poses for Japan.
Fasten your seatbelts
The sharp selloff in the Japanese equity market last week set off a broader reset in equity markets, with the MSCI All Country World Index (ACWI) dropping 1.5%. A trigger for the dramatic drop in the Nikkei (7.3% on Thursday) is likely the spike in Japanese government bond (JGB) yields; for the ten-year JGB, yields have jumped by 40 basis points (bps) since 4 April 2013. The negative impact on equity markets and the economy from rising bond yields has been anticipated even if it has arrived sooner than expected. As we discussed last week, the near-term factors supporting the Japanese equity market remain in place — yen depreciation and relative underperformance vs. other developed markets.
But quantitative easing (QE) in Japan poses its own, unique problems. The Bank of Japan’s (BoJ) asset purchase programme is similar to QE in the US and UK in that the goal is to lower interest rates on government bonds, forcing investors to seek out assets with better returns. But it is different in that it is also part of an intentionally reflationary programme, while in the US or UK inflation is an outcome to be avoided. Ten-year inflation expectations in Japan have risen sharply since the end of last year (see Figure 1), so the BoJ’s programme has already succeeded in changing investor perceptions. But JGB yields would inevitably have to reflect higher inflation and it is not clear how the BoJ intended to offset the risk this poses to portfolios with significant JGB investments. In contrast to the US, where the majority of Treasuries are held by foreigners, and banks own just 2% of the market, in Japan banks and insurers have more than 35% of outstanding JGBs on their books. It is no coincidence that the financial sector fell the most on Thursday, dropping more than 9%.
Figure 1: Japanese inflation expectations*
Last data 24 May 2013. *Average 3-6 year breakevens. Source: Bloomberg, J.P. Morgan Asset Management.
The Japanese market’s decline was not an indication, however, of a broader reverse in risk sentiment: ten-year US Treasuries have remained (just) above 2%. The weakness in US equities is a consequence of further indications from the Fed of a slowdown in the bank’s asset purchases. That markets will weaken as liquidity from the Fed recedes should be no surprise since this is what happened when previous rounds of QE ended (see Figure 2). The transition to a post US QE world will be turbulent, but with fundamental drivers for equities still supportive, investors should tighten their seatbelts instead of reaching for the parachute.
Figure 2: US money supply and equity markets
Last data 24 May 2013. Source: US Federal Reserve, J.P. Morgan Asset Management.
Analysts have noted that much of the apparent deleveraging that has taken place since the onset of the financial crisis has been more apparent than real, as debt was simply transferred from the private sector (be it households or corporations) to the public sector. For most of the world, total debt-to-GDP ratios have continued to increase (see Figure 3). The allocation of the debt is to some degree not significant as ultimately it is a country’s citizens who are responsible for it whether as taxpayers, employees, or individual debtors.
Figure 3: Debt-to-GDP (public + household + corporate debt)
Last data 2012. Source: IMF, BIS, J.P. Morgan Asset Management.
Looking only at debt-to-GDP ratios may make the problem appear worse than it is, however. A country has more than just the income generated by the economy each year to pay its debts. When a debt collector is trying to recover money owed, the first question is how much the individual can pay from their income. If the income is not sufficient, the next question is what assets does the debtor have that they can liquidate to service the debt. Similarly for a country, the nation’s wealth, either in the form of companies the government may own, or the assets of its citizens, can be used to meet financial obligations.
Viewed through this perspective, the indebtedness of several European countries looks quite different than commonly assumed. Measured against income, households in Portugal and Spain are among the most indebted in Europe. But relative to assets, the ordering of countries changes. Italy has one of the lowest household debt-to-asset ratios while Germany’s is among the highest (see Figure 4). Italy’s wealth is a key reason we have long been confident the country would continue to meet its obligations. While it is certain that the global increase in debt levels will ultimately lead to either lower growth rates as income is redirected from consumption to savings, or to losses on the part of creditors, to anticipate where the risk lies it is important to look beyond GDP.
Figure 4: Household debt ratios
Last data 2012. PT = Portugal, ES = Spain, FR = France, IT = Italy, GR = Greece, DE = Germany. Source: ECB, J.P. Morgan Asset Management.