current Japanese inflation? ..there is none

Deflation means that prices in general are falling.  If this is the case, it’s better to put off buying new things for as long as possible, until they’re 100% absolutely needed.  That’s because anything you buy today will be cheaper tomorrow.

After a while, non-consumption becomes a habit, and an economy stagnates.

Conversely, in an inflationary environment, everything is more expensive tomorrow than it is today.  So consumers buy in advance.  In addition to things they need, they may also purchase items they have no intention of consuming.  They may think that keeping physical objects which they can later resell is a better way of preserving or enhancing purchasing power than keeping savings in the bank.

Japan has been in a deflationary economic funk for over a quarter century.   When Shinzo Abe became Prime Minister of Japan in late 2012, he decided to attack deflation as a way of boosting economic growth.  He had a plan that has become famous for its three “arrows”:  a massive depreciation of the yen, large-scale government deficit spending, and corporate/regulatory reform.  Each of the three should have been enough by itself to spark inflation.

The expense of the plan has been enormous, both in terms of the loss of international purchasing power of yen-denominated assets and in increased national debt.

The result after close to four years?   ….as the Tokyo government reported last week, no inflation at all.

How can this be?

From its outset, I’ve believed that Abenomics would be unsuccessful.  I thought the stumbling block would be corporate reform.  The earliest evidence that would indicate I would be wrong would, I thought/think, take the form of an effort to remove the legislative barriers to reform that the Liberal Democrats in the Diet had installed after the deflationary crisis had already begun.  So far, for all practical purposes there’s been nada.  So I continue to be convinced that corporate leaders will resist any changes to the status quo, aided as they are by the Diet’s removal of any levers to force reform from the outside.

Of course, any inflation-induced oomph to consumption won’t last forever.  People and institutions adjust. If nothing else, consumers run out of storage space for the extra stuff they’ve bought.  They then have to throttle back their spending   …or rent a storage unit  …or contemplate a McMansion.

What’s surprising to me, however, is that the same reluctance to spend–although perhaps not to the same degree–is evident in both the US and in Europe.  We might figure that the austerity approach of EU countries wouldn’t exactly spur consumers on.  But the lack of inflation and the paucity of mall-storming or website-crashing consumption in the US after eight years of extraordinary stimulus seem to argue that the overarching economic theories about how to induce inflation are incorrect.

Demographics as the cause?

 

demographics and interest rates

In an op-ed column in Financial Times yesterday, Gavyn Davies wrote about the effect of demographics on interest rates.  His conclusion seems to be that demographics–not cyclical factors–may be the entire story behind why interest rates can remain so low without sparking an increase in business investment.

The demographic argument has three aspects:

–the slowdown in growth of the working population means that companies need to spend less on productivity-enhancing machinery.  This means lower issuance (supply) of corporate debt finance, therefore less upward pressure on rates.  I’m not sure I buy this, but one might equally argue that the price of tech machinery always falls and arrive in a way I find more plausible at the same conclusion

–life expectancy is increasing.  Therefore workers have to save more to support themselves after they retire, thus increasing demand for bonds

–a large proportion of the population is working, meaning the number of savers is high  …and workers save more than non-workers.  This percentage will gradually decrease as the Baby Boom retires.  But for now the population is in prime saving mode.  This, again, means high demand for bonds.

According to a Federal Reserve research paper Davies cites, demographics explains basically all the downward pressure on rates since 1980.

My reaction?

I think that we’re now truly at a point of inflection with interest rates.  I’m torn between two lines of reasoning in support of that conclusion, however.

The demographic argument is effectively that the current regime of extraordinary efforts to keep interest rates low is doing more harm than good.  It hurts savers, compelling them to accept lower returns for their savings than they would get otherwise, while having no positive effect on corporate borrowers.  If anything, the current stance of world monetary authorities mere fuels speculative financial markets activity.  Therefore, extraordinary money stimulus should be removed.

On the other hand, as they say, the market doesn’t bottom until the last bull capitulates.  In the current situation, this translates into:  the economy doesn’t begin to grow more vigorously until the last growth advocate begins to despair that the turn will never come.   That demographic explanation, i.e. abandoning the conventional business-cycle view, can be seen as evidence of that despair.

 

I don’t expect that rates will rise quickly or that they’ll rise very much–another aspect of the demographic argument that the conventional view of the “normal” level of rates has them pegged much too high.

Initiating the process in a systematic way will, however, gradually dispel the anticipatory anxiety about rate rises currently in financial markets.  That should, if nothing else, make for smoother sailing.

 

 

 

the EU today: structural adjustment needed

Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.

How should an equity investor proceed?

There are two schools of thought, not necessarily mutually incompatible:

–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd.  This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention.  If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services.  These will almost certainly outperform the market.

The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.

–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well.  The result is that they don’t do as well as similar companies elsewhere.  I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.

It may be that the local market is offended by brash upstarts.  It may be that local portfolio managers deal only in book value and dividend yield as metrics.  It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock.  One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.

 

The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time.  Because of this, and because of Brexit, the UK assumes greater importance for me.  So, too, Hong Kong, as an avenue into mainland China.  And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.

 

A final thought:  one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices.  Both areas have relatively old populations.  If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade.  I don’t think this is correct, but as investors we should all be attentive to possible signs.

 

demographics, aging populations, and China

I first learned about the importance of demographics from the stock market from an economist at Donaldson Lufkin & Jenrette (which was ultimately acquired by Credit Suisse) in the mid-1980s.

He used to say that you can’t just manufacture a whole bunch of 30-year olds out of thin air–in other words, that a country’s population profile can have a profound influence on consumption patterns for a very long time.  Yet, in the rough and tumble of everyday trading on Wall Street, demographics is often forgotten.

At that time, his main point was the enduring influence on consumption of the post-WWII Baby Boom.  The sheer size of the cohort was important.  But not only that, but so too was its aging–and the resulting age-related shift in their buying habits.  Today, I imagine he would be stressing the age-related fading of the Baby Boom’s influence on consumption, as well as the issues surrounding the cohort’s longevity in retirement.

There are already two examples of aging advanced economies where the work force is significantly older than in the US.  They’re Japan, whose workforce is the oldest in the world and which has already been shrinking for many years due to age; and the EU, whose workforce age is about midway between the US and Japan.

I’ve written often about the social/cultural basis for Japan’s protracted economic decline.  I think this is the main reason, both for that country’s quarter-century of stagnation and why Abenomics won’t work.  But sometimes I wonder how much of Japan’s troubles are simply demographic–and therefore a harbinger of what may be in store for the US at some point.  It doesn’t help my mood that the next-oldest area in the world, the EU, is exhibiting many of the same symptoms that Japan did in the 1990s.

Although I’m not sure how well-known it is, China is, despite all its current economic dynamism, the other important aging country–thanks in large part of the policies of Chairman Mao.  Stratfor (a service I don’t subscribe to but which has competent analyses of world affairs) has just published a good summary of the situation.  The prose is a little too breathless, in my view, but the facts are basically correct.  China is facing workforce retirement issues comparable to those in the US.  Its industrial base is relatively unstable,  It’s in the early stages of transformation from labor-intensive, export-oriented manufacturing, to higher value-added production.

It seems to me that the new Chinese administration is well aware of its demographic problem and is taking sensible steps to redirect its economy to cope.  In fact, Beijing appears to be acting as if its aging workers are its principal long-term issue   …which I think it is.  That would also explain why China is so willing to sacrifice short-term economic growth in order to establish a more advanced, and more stable industrial base.  It would suggest, as well, that investing in basic industry in China–no matter how cheap the companies look–would be (to my mind, anyway) a big mistake.