The below graph reflects the outperformance of Japanese equities since the November 2012 election in Japan, and the introduction of “Abenomics.” Plus, we see that equity markets recovered quite strongly and rapidly after the 2008 financial crisis and the subsequent provision of central bank liquidity into financial markets. However, Chinese and Korean equities have not done much since mid-2011.
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While the weakening yen has supported the Japanese export machine and corporate profits post-2012, the big question is whether or not this trend can continue. What makes the current business cycle different from the prior business cycle is that Japan may be exporting into soft economies in both the United States and Europe for some time.
Can Japan increase sales in the United States and European Union?
The United States has seen the labor force participation rate decline for both men and women post-2008, while the U.S. Federal Reserve Bank under Ban Bernanke has sought to reduce the chronic “structural unemployment” through low interest rates and quantitative easing measures. Europe has barely avoided its seventh consecutive quarter of recession, with Germany, Austria, Belgium, and France gross domestic product levels hovering around 2008 peak levels since early 2011. The European Union as a whole has seen GDP fall approximately 3% from the 2008 peak levels. The bellwether economy for European Union import and export activity, the Netherlands, is on par with the European Union recession, with its GDP down 3% versus the 2008 peak level. So it’s not easy to be sanguine about trade-related economic growth in “real terms” in the European Union, to include imports and exports from Asia. However, for Japan, trade growth in nominal yen terms is still “growth” from its perspective. Even though nominal yen-denominated export growth is an accounting-based source of growth, it’s still more yen income for Japanese corporations, and a positive factor in removing deflation from the economy.
Will Japan grow as China loads up on debt?
Plus, much ado has been made recently about China’s debt, which appears to be making investors increasingly cautious. Hedge fund manager James Chanos of Kynikos Associates continues to consider China to be “a great place to be short,” and has been critical of the Chinese banking system for some time. For additional discussion of China-related developments, see Export/Import Series: “China’s Wage Inflation: Bad News For Corporate Profits and Banks,” to include, “The Delicate Dance of the US Fed and the Central Bank of China”, and “China Tightens Monetary Policy: Will This Be A Japan 1990 Redux?”.
A recent research report by JP Morgan drew parallels on debt to Gross Domestic Product (GDP) ratios between Japan in the 1980s and modern China. The report noted that the Japanese credit-to-GDP ratio grew from 127% to 176% from 1980 to 1990, when the bubble burst, while the China debt-to-GDP ratio has gone from 105% in 2000 to 187% in 2012. As such, China’s debt-to-GDP growth has been a bit more aggressive than Japan’s debt-to-GDP growth ratios during Japan’s “bubble economy “ of the 1980s.
However, there’s the distinction that China is somewhat different from Japan, in that China is much more focused on lower-end manufactured goods and is ramping up from a lower manufacturing economic base. In contrast, Japan was seen as taking over the semiconductor industry in the 1980s. In 1989, the top ten largest banks in the world were Japanese. Despite this distinction, the concern with China’s debt is that the lion’s share of this debt is banking system debt, which is secured by real estate and commercial credit—just like Japan.
Like Japan in the 1990s and the United States after 2008, there’s always the threat of debt that wasn’t fully accounted for—either in the shadow or unregulated banking sectors or (in the case of China) hidden debts in the form of off-the-book obligations of local governments and state banks. So some analysts, such as Gordon Chang, think that the real level of debt in China is far greater than the official level of around 20% of gross domestic product, and is realistically closer to between 90% and 160%—between the United States (103%) and Greece (160%). Investors like Chanos are skeptical of the Chinese government’s ability to manage the banking sector’s extension of credit in the face of decelerating economic growth—much like Japan after 1990, which experienced a collapse of equity prices as a result.
The Chinese government has recently announced that it will focus on more balanced growth by encouraging more domestic consumption relative to its reliance upon export growth in order to maintain targeted growth rates. The governor of the China Central Bank, Zhou Xiaochuan, mentioned, “Domestic and external economic conditions are unusually complicated.” June export data came in -3.1% versus +3.7% expectations year-over-year, while import data came in at -0.7% versus +6.0% expectations. Though recent July data shows improvement, the deceleration of China’s economic growth and rapid increase in debt, in conjunction with Japan’s “Abenomics,” merits close attention for investors focused on Asian markets.
Should China face challenges in managing the massive accumulation of both public and private sector debt in the future, China’s shortcomings could be Japan’s advantages, supporting the continued outperformance of Japanese equities over Chinese and possibly Korean equities, as reflected in Wisdom Tree Japan Hedged (DXJ) and iShares MSCI Japan (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY).