Must-know: Is Japan’s Great Exodus of investment ending?
Capital formation in Japan
The below graph reflect the changes in capital formation in Japan. As with fixed capital formation in the prior graph, gross capital formation has been on a long-term downward trend, though it seemed to be on a path to recovery from 2003 to 2008, until the global financial crisis hit.
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What is gross capital formation and why is it important?
Gross capital formation consists of outlays on additions to the fixed assets of the economy plus net changes in the level of inventories. These items include commercial and industrial buildings, roads, hospitals, schools, and private housing. As we noted in the first part of this series, China has been involved in a massive build-out of its manufacturing and industrial base since 1978 (as reflected in the dramatic growth in gross capital formation) while Japan (being a more mature economy) has seen declines in this area of the economy post-1990.
The dramatic growth in new invested capital in China reflects a country entering a major phase of development. In contrast to China’s new birth as a more free-market economy stands Japan’s decline as a mature economy. Japan has had little need to build new factories or acquire new equipment in excess of historical rates. As shown in the first graph in this series, Japan seems to have hit its investment peak around 1990. By that time, Japan had finished building out the foundation of its post-WWII manufacturing base.
Since then, Japan has maintained a very large manufacturing base and a significant gross domestic product, or GDP. However, the rate at which old capital is being replaced by new capital investments continues to decline. So GDP growth has also stagnated in recent years, with current real GDP levels pretty much unchanged versus 2005. As ongoing trade surpluses have forced Japan’s currency to dramatically appreciate since the 1980s, Japan has slowly become a high-cost production center, replaced by China, Korea, and other regional economies as the region’s low-price manufacturing base.
Increases in productivity can offset the increases of a rising domestic cost base. However, in Japan’s case, productivity growth rates haven’t been able to outpace the rise in its domestic price level, resulting in stagnating wage growth and living standards. As we discussed in a related series on the US economy, robust fixed investment in higher-productivity technologies is key to sustaining economic growth. An economy that relies excessively upon consumption without maintaining sufficient levels of savings and investment will likely jeopardize its long-term growth rate and living standards for its workers.
In Japan, new economic growth in a wide array of manufacturing has simply wound down or failed to grow. Such are the symptoms of a mature economy with limited growth prospects. However, change could be on the way in the form of “Abenomics,” and perhaps the above trend line could slow or possibly reverse in the future.
What “Abenomics” means for gross fixed capital formation
As we noted in a previous series, “Abenomics” involves inflationary scare tactics designed to get Japan’s consumers spending. Plus, Japan’s currency has weakened 33% against the Chinese yuan and US dollar since Abe was elected in November last year. Should the yen continue to weaken under “Abenomics” and Japanese consumers spend more and save less as a result of growing corporate profitability, it could become increasingly viable for capital investment to pick up in Japan.
What to watch for
Should the yen continue to weaken against the US dollar and Chinese yuan, the cost base differential between Japan and China could continue to decrease, leading to an improvement in Japan’s terms of trade vis-à-vis China. It’s important to note that Japan’s wages have remained stagnant while its currency has dramatically appreciated over the last few decades. Contrary to these trends, China has experienced dramatic wage inflation, while its currency has remained largely unchanged against the yen since 1996. Should this 30-plus-year secular (long-term) trend continue to reverse in a significant way, we could see a major change in the interrelation of the Asian economies, with Japan returning to its prior role as a more significant manufacturing base.
Why the bull market in Japan could go into overtime
This decades-long relationship shows early signs of reversing itself under “Abenomics.” The Japanese Yen has a long way to go before reaching its Regan Era levels of 260 to the dollar, just before the Plaza Accord led to the yen’s secular strengthening to date. However, should Abenomics inflationary scare tactics steer the yen back on course for Regan-era levels of weakness versus the dollar, investors could see major changes for Japan, and the Japanese equity markets would very likely head deep into bull market territory for a long time.
As 2013 progresses, investors could see a continued outperformance of Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ could outperform both EWJ and other Asian equity indices, please see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.” Plus, as Japan pursues unprecedented monetary expansion, and the US Fed ponders monetary tightening, Japanese equities could also outperform broad US equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV).
For related analysis, please see the following articles.