Opinion

James Saft

The Abenomics effect deflates

June 5, 2013

June 5 (Reuters) – The Abenomics attempt to revive Japan is
already flagging, a development which will hurt equities
worldwide.

Nikkei 225 stock index futures fell another 4.22
percent ahead of Tokyo’s Thursday trading session, as investors
reacted with disappointment to Prime Minister Shinzo Abe’s plans
for structural reforms. That would take the index’s fall
well past the bear market barrier of 20 percent down from its
May 22 peak.

Any loss of faith in Abenomics, an ambitious cocktail of
fiscal and monetary stimulus poured over a base of reforms, will
not only reverse the stunning gains seen in Japanese markets but
crimp liquidity and stimulus which has been supporting growth
and risky assets elsewhere.

WHAT’S GONE WRONG

The latest down-leg has been prompted by a much ballyhooed
speech by Abe intended to flesh out plans for reforms. The
headline figure, a target of increasing income by 3 percent
annually, was specific as a number, but the route to get there
is vague. Also on offer were new special economic zones with
less regulation, as well as new rules allowing the sale of
nonprescription medication over the Internet.

Hardly the stuff to turn Japan into Silicon Valley.

Abe also said the new rules won’t be debated until the
autumn, an indication that he is less than eager to take on the
many interests which will be hurt by reform.

The moves in financial markets have been particularly severe
precisely because investors moved so rapidly to price in a
revival in Japan over the past eight months. The reality,
however, was always that even with a weak yen and a bit
of inflation, Japan was going to need structural reform in order
to sustain the gains. That now seems less likely, and the
response of the government to market reverses has been less than
sure-footed.

A rapid rise in market interest rates has also caused
problems, raising the possibility of destabilizing losses for
the large-scale investors in Japanese government debt within the
Japanese financial system. Higher rates also present a
sequencing issue, as heavily indebted Japan will face a rising
bill for its financing before higher tax revenues roll in.

Finally, at the same time the Nikkei has fallen, the yen has
strengthened, undermining a central effort of Abenomics: making
Japan more internationally competitive. While some evidence
indicated that Japanese companies are simply raking in higher
profits on newly cheap exports rather than gearing up
production, a rising yen both undermines the Abenomics project
and punches a hole in the thesis for owning Japanese stocks.

WHY IT MATTERS

While it is clear why this is all a big deal in Tokyo, a
loss of faith in Abenomics may prove to be quite tough for
investors elsewhere.

First off, the sudden rise in the yen will have hit carry
trade investors hard. The carry trade, where one funds in a
low-interest rate currency and hopes to make more by investing
it elsewhere, is as old as it is dangerous. While the yen was
falling in value and government bond-buying by the BOJ was
driving rates lower, this was a fabulous trade and one which was
likely helping to drive demand for risky assets in the U.S. and
elsewhere. These last two weeks, not so much.

In fact, while most of the attention on the U.S. bull market
has centered on either support from the Fed or the belief that
the U.S. economy is turning a corner, the bull market of the
past couple of quarters has been tightly linked with Abenomics.
An active BOJ created not only liquidity but helped animal
spirits among investors far from Tokyo.

HOW IT MAY PLAY FOR U.S. INVESTORS

To be sure, the project isn’t doomed, and the BOJ and Prime
Minister Abe won’t soon give up. Even so, reform projects, from
selling decongestant on the Internet to making it easier to set
up international schools, don’t seem equal to the task of
helping Japan overcome its demographic and economic challenges.

And while flagging faith in Abenomics will be bad for
Japanese shares, the damage to U.S. ones will be far more
diluted. A reversal in Japan makes it even less likely that the
Federal Reserve will follow through on talk about tapering bond
purchases, especially if the selloff in Japanese debt gains
momentum.

That will provide some support, as will a stronger yen,
which will be a small benefit to U.S. companies which may be
losing out on sales.

Here is the big vulnerability – that people take the lesson
of QE from Japan, that it doesn’t really work that well and has
high ancillary costs, and apply it to the U.S. If that ends up
putting pressure on the Fed to back away from QE even before
employment and demand recover the market could face very ugly
times indeed.

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