In 2005, the Nikkei equity index shot ahead by 40% while 10-year Japanese government bond yields inched higher by just 15bp.
One is wrong. Either equity investors have become too exuberant about the economy’s recovery and the prospects for sparkling corporate profits to justify punchy valuations, or bond investors have failed to price in the shift from an era of deflation to one of inflation and higher rates to come.
In January, the Livedoor scandal hinted that it is equity investors who have got ahead of themselves. But don’t confuse structural problems in the stock market with fundamental weaknesses in the economy and corporate sector. True, a market whose turnover is dominated by inexperienced day traders punting internet stocks and stagging small-cap IPOs inspires little confidence as an efficient mechanism for allocating capital.
But the renewed health of Japanese corporations is no mirage. They have finally escaped the burden of excessive debt, labour and capacity. They are busily rebuilding ageing plant and machinery, often from cash, so boosting the economy through investment and, by offering more full-time jobs, enabling more confident consumers to play their part in an economic revival based on robust domestic demand.
Liquidity remains abundant, providing support over the next few months for all asset prices. Much agonizing seems to be taking place in Japan as politicians urge the Bank of Japan not to choke off the recovery with an intemperate early tightening of monetary policy. It’s all shadow play. Nothing could be further from its mind. The central bank might well soon review the policy of quantitative easing – flooding the banking system with excess liquidity of up to ¥30 trillion to ensure abundant credit. But don’t forget the first plank of BoJ policy: zero interest rates.
In the era of deflation, zero nominal rates had limited impact. Real rates remained obstinately positive. But as inflation, which first picked up in the second half of 2005, resumes, Japan will benefit from negative real rates in the months ahead and possibly throughout 2006. The BoJ is not the only source of excess liquidity. JPMorgan estimates that the household sector had ¥770 trillion in cash deposits, equivalent to 54% of GDP, when inflations turned positive last summer. Cash in circulation – banknotes and coins – amounts to ¥70 trillion, or nearly 15% of GDP. That’s a lot of money that could go into consumption and asset markets.
In the end, it’s bond investors who might be well advised to watch out. Quietly, bond market participants admit to expecting 10-year yields to rise from 1.5% to 2.5% by the end of the year and before long prop desks and hedge funds will be positioning for this sell-off if they haven’t already.
Almost whatever the outcome in financial markets, the prospects for investment banking in Japan have not been brighter for close to 20 years. Traders will have plenty of volume and volatility to play with, capital raising will kick in as capital investment plans test the limits of free cashflow and as corporate executives start to think beyond dividend increases and share buybacks to mergers and acquisitions.
Tokyo’s investment banks in 2006 are now full of a generation of hungry young bankers, the scent of deals in their nostrils, eager for the chase and frustrated that their complacent overfed bosses in London and New York were so slow coming back off holiday to approve their latest ventures.
If you’re looking for excitement, opportunity and challenge, get yourself to Tokyo.