The world is all perversity. The worst that could happen to investors is stronger global growth, producing weak financial markets. That will happen if Japan picks up this year at the same time as core Europe, and there is a continued boom in the US.
I think synchronized global growth is only 40% likely this year. It’s more likely the Japanese authorities will have to use their last policy option, a massive and continued yen depreciation, to kick-start their economy, so Japan’s recovery will be delayed until next year. But if I’m wrong, stronger global growth will hit world financial markets, particularly US treasuries and emerging market debt and equity.
My view of Japan is that a combination of tax increases and policy contradictions will stop Japanese growth in the second half of the year. Once that happens, having exhausted monetary policy options, the authorities will have only one policy option left to achieve growth – further depreciation of the yen to ¥150-¥160 to the dollar.
Japan’s long-term private capital outflows now recycle most of its current account surplus. At present, only foreigners’ purchases of Japanese equities keep Japan’s long-term capital account from being even more heavily in deficit. This fiscal year 1997-98, more capital will flow abroad because net equity flows will turn negative, while other portfolio outflows will accelerate. That will drive down the yen further, even though Japan’s current account surplus will rise.
Already demands for intervention to stop the yen falling further are being voiced in Japan. But the Bank of Japan would not want to defend the yen by tightening monetary policy. It can sell dollars and buy yen in the currency market. But it would need to counteract the contraction of the domestic money supply this would cause by buying Japanese government bonds to sustain liquidity. The outcome would be an increasing interest yield differential between dollar and yen cash deposits, thus weakening the yen further.
Japan is creating jobs and paying its workers more, despite poor profitability and modest productivity gains. Rising capacity utilization appears to be driving increased investment by the private sector. But come June and July, sales tax increases will destroy all these gains in consumer purchasing power, so that domestic demand growth stops. The cheap yen will cause net exports to bounce and drive up the annual current account surplus, adding about 0.6% points to GDP growth. But the effect of a bigger current account surplus will be overwhelmed by increased capital outflows and keep the yen weak.
What would happen if I’m wrong and Japanese domestic demand continues to recover? It would be great news for the workers of the world: Europe, the US and Japan would all be growing quite strongly by then and the global job market would improve. The Bundesbank and the BoJ would all start thinking of reversing their easy-money policies. So would foreign exchange markets. The Deutschmark and yen would start to strengthen against the dollar. And east Asia would benefit from that big turning point.
But it would be negative for most world bond and equity markets. Sustained economic recovery in Japan would push short-term interest rates above 1% by the year-end. As Japanese and foreign investors were paid more to keep money in Japan, they would stop recycling a large part of the $80 billion a year they send abroad to buy foreign bonds (although FDI outflows would continue, and even accelerate as the yen strengthened). With JGB yields heading through 3.5% towards 4.5% two years out, and the yen appreciating instead of depreciating, the yield advantage of buying New Zealand, Australian and Indonesian paper and a raft of Brady bonds would start to disappear for most Japanese fund managers. And culturally they would like nothing better than to keep their funds safely sleeping in the arms of Japan Inc anyway. Liquidity in world financial markets would take a hit.
And what would happen to US dollar assets if Japan were to stop recycling capital? Current account deficits must be financed by capital inflows. What’s crucial for financial asset prices and the exchange rate is how much capital financing is needed and of what type. A current account financed voluntarily by foreigners buying a country’s bonds and equities is fine. A deficit financed by government borrowing or a reduction in a country’s foreign exchange reserves is not.
The strong dollar has not been the result of an improved US current account. The US current account deficit has been stable, at best, over the last three years. What has boosted the dollar and US financial asset prices was hugely increased net private capital inflows – more than 80% of the extra $84 billion of total capital inflows in 1996 came voluntarily from the foreign private sector.
This huge increase in private-sector capital inflows (mainly to buy US treasuries, but also to buy US corporate bonds and equities, as well as direct investment) improved the US basic balance of payments sharply. The US bond market flourished and the dollar strengthened.
If the US Federal Reserve raises rates further this year, it will support the dollar and attract more capital inflows. However, if the Bundesbank and the BoJ raise their short-term rates, the great private purchase of US treasuries and the era of a strong dollar will be over. That’s because the structural deficit in US external payments remains. And the continued rise in net external liabilities will ultimately exert downward pressure on the dollar.
Rising US bond yields would be the tide that lifts yield boats around the world. That’s bad news for bonds. With equity valuations stretched compared with bond yields already, another 100bp-150bp on bond yields around the world by end-1997 could produce a 20% correction in most global equity markets. The only financial asset class that would do well would be east Asian equities, which would benefit from a weak dollar and export-led growth, which is what they lack the most.
Don’t get me wrong. I’m sticking to the scenario of big economic weakness in Japan and more yen depreciation. But investors must minimize risk and maximize returns across 100% of all the outcomes imaginable. I’m telling my clients to raise cash.
David Roche is president of Independent Strategy, a London-based research firm.
