Highlights in this issue:
– Why has Japan kept interest rates low?
– Why does Warren Buffett favor consortia?
– How deeply has Japan been affected by “Abenomics?”
– What are the investment opportunities in the Japanese market and how can I participate?
Warren Buffett recently visited Japan again (10 years after his last visit). He expressed a bullish outlook on the Japanese stock market and considered raising his stakes. In fact, in recent years, Mr. Buffett has been buying Japanese assets; including Japan’s five largest trading companies and using Japan’s low interest rates to issue large amounts of yen bonds. According to Berkshire Hathaway’s 13F filings, by 2022 Q4, the size of the position has exceeded $13 billion with a conservative estimated net gain of $4.5 billion.
When we do the math, the size of Berkshire’s yen-denominated liabilities exceeded $7.8 billion in 2022Q4. In Japan’s extremely low interest rate environment, the average spread between the yen and the US dollar reached 2.5% in 2022. In the meantime, the yen depreciated by nearly 14% in 2022, so Berkshire was able to save $200 million in interest and make $1 billion in exchange rate profits just from those two factors alone.
Japanese assets have always been an important part of the global asset allocation. Due to the barrier of entry to the Japanese market and the difference in levels of understanding of Japanese assets, overseas retail investors rarely participate. The Japanese bond and stock markets are also highly institutionalized markets. But as a US retail stock investor, it is not difficult to purchase Japanese assets.
Why has Japan maintained low interest rates for so long?
Since the subprime mortgage crisis in 2008, Japan’s central bank has maintained “zero interest rates” as a matter of course and launched “negative interest rates” in 2016; with the current benchmark interest rate at -0.1%. From 2000 to 2008, the Bank of Japan’s interest rate was only 0.6% at its highest, which was the one of the lowest in the world. The last time Japanese citizens could obtain a decent interest rate on their money was in the early 90s before the asset price bubble burst.
The reason for keeping interest rates low is to stimulate the economy and to increase domestic demand and investment. The Japanese economy went through a “lost decade” since the economic bubble burst in the early 1990s. This was accompanied by an aging population, a weakened labor supply and an increase in social welfare spending. The elderly who experienced the burst tend to be more conservative in their consumption and the domestic effective demand is insufficient while the consumer market is saturated.
At the same time, Japan’s high government debt ratio must be matched by low interest rates. Japan’s debt to GDP ratio reached 262.5%; which is more than all G7 economies combined and more than double that of the United States. This means that once interest rates rise, government spending may likely increase steeply, potentially causing the marginal increase in interest on the national debt to more than double that of the US.
In addition, another reason why Japan’s low interest rates have lasted so long is the “liquidity trap.” Despite the massive easing of interest rates by the Bank of Japan, Japanese companies are not willing to increase borrowing and investment and are not optimistic about the economic outlook. Japanese companies employ for life, which makes it difficult to support aggressive expansion strategies. Instead, they often choose to reduce costs to increase efficiency, which is why Japanese companies are also global leaders in controlling costs. At the same time, Japanese individuals and households prefer to use cash, which also reduces the role of interest rates in the economy.
The Japanese “consortia”
After World War II, Japan was first placed under the trusteeship of the United States. The post-war period was followed by the historic opportunity of the Korean War, which led to 20 years of rapid growth and the emergence of numerous domestic conglomerates. The Zaibatsu – as they were called at the time – had a monopoly on the livelihood of the people. The consortium economy led to an oligopoly that covered a whole range of businesses from manufacturing to finance.
But more importantly, they controlled the banks, which is the heart of the Japanese economy.
Japanese companies had an advantage in the global inflation of the 1970s and early 1980s, due to their technology-oriented “high quality growth” model. But the 1985 “Plaza Accord” was the biggest turning point, as Japan’s huge trade surplus had made it the world’s largest exporter and gave it an edge over its competitors, including the United States. The US called a meeting of seven finance ministers and central bankers at the Plaza Hotel in New York and reached an agreement that ostensibly limited the appreciation of the US dollar against other currencies, but in fact was mainly aimed at Japan, which was riding high at the time. The sharp appreciation of the yen led to a decline in export competitiveness, which had a negative impact on Japan’s economic growth.
What’s more, the Bank of Japan did not adopt a tightening monetary policy (it can also be said that the US did not allow it to). And the loose monetary policy led to a rapid rise in asset prices, which contributed to the formation of the economic bubble in the late 1980s. The intersection of business and mutual shareholding between the members of the large consortia also allowed further risk accumulation. More importantly, as the consortia were made up of banks, bank lending under the low interest rate policy further increased leverage. In that era of rapid asset price inflation, anyone who had any money – whether their own or borrowed – invested in the stock and property markets.
Due to the excessive expansion of credit, the Japanese economic bubble finally burst in 1990. The stock market and exchange rate plummeted, asset values declined, many companies began to go bankrupt. The economy declined and financial institutions also began to go bankrupt in the late 1990s.
The consortia were significantly weakened after the 2000 dot-com bubble and the 2008 mortgage crisis, and the Japanese government intended to reduce their influence on the economy. However, the consortia are still an important pillar of the Japanese economy.
Abenomics put the Bank of Japan in a difficult situation
After taking power again in 2012, Shinzo Abe served as Prime Minister for 8 years and successfully launched his “Abenomics”. Its original intention was to regain the “lost decades” by stimulating the economy through more flexible and loose fiscal policy and monetary policy than before in order to structurally reform the economy.
In terms of fiscal policy (such as raising government spending and tax cuts to stimulate economic growth), Japan mainly focused on infrastructure and support for businesses. In terms of monetary policy, under the massive quantitative easing policy, the Bank of Japan purchased large amounts of government bonds and other financial assets which increased liquidity in the market, lowered interest rates and stimulating inflation for economic growth. Although the inflation rate still did not reach the expected 2%, Abenomics achieved some success as the global economy recovered.
Over time, a number of problems emerged: the two most obvious ones being increased pressure on government debt and the difficulty in adjusting monetary policy by the Central Bank.
Before 2016, the Bank of Japan (BOJ) increased its monetary base with a quantitative bond purchase program, from 50 trillion yen per year at the beginning to 80 trillion yen later. But in 2016, the BOJ furthered quantitative easing by adopting the yield curve control policy (YCC – Yield Curve Control) as the core of its monetary policy with unlimited bond purchases.
The YCC set the short-end rate around -0.1% and the 10-year rate around 0%, with a margin of ±0.25%. In other words, once the interest rate on Japan’s 10-year government bonds exceeded the 0.25% ceiling, the BOJ would purchase unlimited 10-year government bonds at 0.25%. This also made the BOJ the largest holder of Japanese government bonds and it has absolute control over the bond yields.
Once there was a buyer on the market with unlimited funds, other bond market participants were less likely to invest. At one point in late 2022, no one traded 10-year Japanese government bonds for several days.
At the same time, unlimited purchases of government bonds also lowered the yen’s exchange rate. So in the second half of 2022, when major economies around the world were entering a rate hike cycle due to inflation, the Japanese industry operated in the opposite direction. This devalued the Yen by more than 30% at one point. Concerned about the reduced defensive capacity of the Yen, the BOJ decided to widen the margin of long-term interest rate fluctuations from around ±0.25% to ±0.5% in its December 2022 monetary policy meeting.
But this does not reduce the status quo of Japanese government bonds being controlled by the Central Bank, nor does it lighten the Central Bank’s balance sheet.
The policy maker who insisted so much on an easing policy is the former Governor of the Bank of Japan, Haruhiko Kuroda, who has served for 10 years. In April this year, Kazuo Ueda successfully took over and the market’s focus shifted to gradually withdrawing from unlimited easing in order to achieve a “normal” monetary policy.
If properly handled, a smooth exit from the YCC may make the Yen the most valuable currency investment. If this were to occur, it’s possible that Japanese government bonds could then also achieve normal liquidity and the Bank of Japan will have more room for monetary policy.
Why has the Japanese stock market become a safe-haven for investors?
Due to the lack of volatility in the bond market and the increased volatility in foreign exchange, Japanese stock market assets have naturally become preferred by investors and Japanese stocks have become more available for trading.
Warren Buffett’s philosophy, naturally, would be to choose stocks from companies with strong moats, competitive advantages, stable management, good earnings, low valuations, long-term stable cash flows and preferably some preferred stock. In the Japanese market, don’t these criteria point to the “consortia” that once dominated the market and still have residual influence?
In August 2020, Warren Buffett was exposed as having holdings (over 5%) in five members of the consortia: Marubeni Corporation, Mitsui & Co, Mitsubishi Corporation, Itochu Corporation, and Sumitomo Corporation. In terms of returns since then, Marubeni Corporation (ranked around 50), which has a slightly lower market capitalization, is over 270%, while the rest are in the 80-150% range; all far outperforming the Nikkei index.
Compared to the US stock market, the Japanese stock market has the following characteristics:
1. Different industry weights. The Japanese market has performed roughly the same as the S&P 500 since the pandemic. Since the S&P is weighted in technology as well as consumer companies, it performed better in 2020-2021. The Nikkei 225 is weighted in traditional corporations in a wide range of sectors, including manufacturing, pharmaceuticals, finance, telecommunications and other industries, which gained market favor and performed better in the tightening environment of 2022.
2. Lower valuation. The Nikkei has doubled since the start of Abenomics, but the valuation pivot is still below 20 times the P/E ratio (expected P/E ratio), and is currently less than 17 times, which is lower than that of the S&P 500.
3. Expected yen appreciation. Japan is also affected by imported inflation, and the average CPI increase over the past year was above 3% year-on-year, reaching 4.3% in January 2023, the highest value since the burst of the economic bubble. Our expectation is that if Japan’s long-term inflation level can reach the policy target of 2% in the long run, the central bank may likely exit from the infinite easing policy, and thus the yen would probably appreciate. In addition, the yen itself is considered by some to be one of the safe-haven currencies. As such, we anticipate that at the first signs of a global recession, investors will become more risk averse and turn to the yen.
Therefore, we believe that for investors who want to diversify their portfolio from a single market, the Japanese stock market may be the perfect complement to investments in the US stock market.
How can overseas investors invest in the Japanese market?
While global central banks are nearing the end of their rate hikes, we believe there is a good chance that a post-inflation stagflation or recession will follow, so investing in Japan may be the best hedge.
The two easiest ways for the average investor who has not been studying the Japanese market and Japanese companies to invest are:
1. Choose a large integrated company. Like Warren Buffett, investments in a consortium with a wide range of industries and strong competitiveness is naturally a good choice. But note that Warren Buffett’s positions have a certain “Buffett aura.” Other top Japanese companies often excel in their respective fields as well.
2. Invest in secondary market ETFs and futures directly. There are a variety of Japanese ETFs on the market weighted in companies of different values and capitals.
Investors who have access to the Japanese market can trade Japanese stocks directly in the secondary market. Most brokerage firms with unified purchasing power can assist their customers to buy Japanese stocks and save on interest rates. Of course, investors should also be aware of the potential appreciation of the Yen in anticipation of the Bank of Japan’s exit from unlimited easing.
For indirect investment through the US stock market, retail investors can choose to purchase ADRs of Japanese companies listed in the US. Of course, in this case the trading currency is the US dollar and the exchange rate gain or loss is reflected directly in the stock price. Keep in mind that a specific ADR may not be actively trading, and large orders require attention to liquidity.
Disclaimer: The information contained in this material is for informational purposes only and is not intended to provide professional, investment, or any other type of advice or recommendation, nor does it create a fiduciary relationship. TradeUP does not make any representation or warranty, express or implied, regarding the accuracy, reliability, completeness, appropriateness, or sufficiency of any information included in this material. Certain information may have been provided by third-party sources, and while believed to be reliable, it has not been independently verified by TradeUP. Any investment decision should not be made solely in reliance on this material, as the information is subject to change without notice. Securities and derivatives transactions involve the risk of loss, including loss of principal. Past performance is no guarantee of future results. It is important to carefully consider the potential benefits and risks involved before making any investment decisions.