The Bank of Japan finally exited its negative-rate regime. Far from being restrictive, though, the move is paradoxically likely to be net stimulative. Stocks are set to benefit from a secular shift of domestic investors toward equities, prompted by entrenched inflation and monetary policy too timid to tame it, while FX hedging is poised to drive the yen much higher than markets expect.
The truth is rarely pure and never simple. And so it is with the investment implications now that Japan has dropped its almost decade-long fraternization with negative rates and its yield curve control policy. The reflex is to anticipate more restrictive financial conditions, lower inflation and weaker stocks.
However, the absence of negative rates will allow Japanese banks to lend more, bolstering inflation that is already becoming embedded. Moreover, years of anemic price growth have led to a large underweight in equities and an overweight in bonds among domestic investors, which is likely to be reversed as the penny drops that higher inflation is here to stay.
We now know a lot more about negative rates than we did prior to the GFC, with a wealth of research on their impact on bank profitability. Far from being stimulative, Europe’s experience shows negative rates have very likely been restrictive for the economy, squeezing banks’ profitability and their net interest margins, and impeding their willingness to lend.
In Japan, banks’ operating margin began falling soon after the BOJ took its policy rate negative in 2016.
That’s also been reflected in bank lending. The yield curve is traditionally a good signifier of banks’ profitability and hence their propensity to lend. But banks’ loans relative to their assets in Japan have continued to fall despite the steepening of the yield curve over the last two years. Negative rates are the likely culprit.
If negative rates have been restrictive, then exiting them is set to be stimulative – especially if, as is the case in Japan, the rise in rates is likely to be gradual and modest despite rising price growth, underscored by BOJ governor Ueda’s comments after today’s rate decision that “there is still some distance to 2%” inflation.
Why the inertia? Decades of low inflation have left the BOJ with a blind spot to price growth that is becoming problematic. Headline CPI in Japan is falling but remains at all-time highs outside of consumption-tax hikes, while core-core CPI is stuck near its peak. Under the surface, there are signs that inflation is becoming more embedded, with almost all inputs to the CPI basket rising over the last year, much higher than at any other time ex-consumption tax rises.
Inflation expectations are coming down only slowly from series highs, and the risk is rising that they become unanchored from the BOJ’s inflation goal, especially with the bank’s likely muted reaction function.
Years of placid inflation have led to a false sense of security, with households and corporates in Japan building up significant overweights in bonds to the detriment of equity ownership. But as stubborn inflation begins to have an increasingly destructive impact on the value of JGBs – compounded by rates finally being untethered from negative levels – they will begin to look ever less attractive than equities.
In fact every sector in Japan’s allocation to equities has either fallen or moved sideways over the last 25 years. Only the foreign sector’s allocation has risen significantly, to 30% of the total (blue line in chart below).
Source: Japan Exchange Group
This potential longer-term, highly-supportive flow from domestic investors seeking shelter from stubborn inflation, as well as foreign investors riding upward momentum, promise to sustain the equity market in Japan – even with the BOJ no longer buying ETFs. Further, Japanese investors may see now as a good time to reduce exposure to US equities, whose stellar performance has been boosted by the weak yen, in favor of the home stock market.
Nothing moves in a straight line, of course, and stocks are likely to experience some turbulence from current overbought conditions, but the bigger picture is of a market that has the potential to drive much higher.
That’s incidentally in contrast to the latest Bloomberg MLIV Pulse survey, where 44% of the respondents saw the BOJ’s first hike marking the “beginning of the end” for Japan’s stock-market’s bull run.
It’s not just inflation hedging that will make equities more attractive, but also fundamental reforms in the corporate sector. The third arrow of Abenomics has taken a decade to arrive, but it’s now hitting its target. Better corporate governance and greater focus on profitability are long-term positive for the stock market.
Buybacks in Japan have been rising, boosting EPS; about 45% of Nikkei 225 earnings are being paid out as dividends, from an average of 35% in the mid 2010s; while a recent Japan Exchange Group directive pressuring firms to support their book values has led to a notable drop in the number of companies with a price-to-book ratio of less than one, and a rise in the average ratio.
Where non-negative rates will have a nearer-term impact is in the yen. The market seems remarkably confident a large move in the direction of a stronger yen is not on the cards, with the FX options market pricing only a 0.2% chance USDJPY hits 130 by the end of June. USDJPY is back above 150 today on the back of disappointment on the rate outlook.
But Japan’s large net creditor position (the world’s biggest) means that a trickle of currency hedging by domestic holders of foreign assets could turn into a flood. The backdrop of a weaker yen has encouraged investors to become underhedged. Life insurers, one of the largest currency hedgers, are representative, letting their hedge ratios drop to under 50% over the last few years.
FX hedging will push the yen stronger, eliciting yet more hedging. It is this dynamic that drove USDJPY to rapidly drop 20% through the first half of 2016 (which can be seen in the rise in the hedge ratio around that time in the above chart). The 500-1 odds offered on USDJPY touching 130 by the end of Q2 – a level it was at little more than a year ago – sound very generous.
If inflation becomes ingrained, then eventually the yen will succumb to it, but in the shorter term, hedging flows as well as capital repatriation are likely to be the currency’s bigger driver. That also means an added fillip to unhedged foreign holders of Japanese assets.
