Is Japan’s investment turning the corner, or beyond help?
Japan’s fixed capital formation
The below graph reflects the ongoing decline in fixed capital formation in Japan. Since Japan’s bubble economy burst in 1990, investments have been in a long-term phase of winding down. However, there has been a slight, though potentially ominous bounce recently. This article examines the trend in capital formation in Japan and considers future prospects for a sustainable turnaround in investment, as well as the broader Japanese economy.
Interested in DIA? Don't miss the next report.
Receive e-mail alerts for new research on DIA
What is gross fixed capital formation and why is it important?
Gross fixed capital formation measures the value of acquisitions of new or existing fixed assets (think factories, machinery, and buildings) by the business sector, government, and household less the disposal of fixed assets. This number reflects the extent to which the “new value added” in an economy is invested versus consumed. 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.
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. As the above graph reflects, 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.
New growth in a wide array of manufacturing has simply wound down. 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 trendline could slow—or possibly reverse.
“Abenomics”: Larger budget deficits and aggressive monetary policy
As we noted in the first part of an earlier series, Japan’s new Prime Minister, Shinzo Abe, in conjunction with Bank of Japan Governor Haruhiko Kuroda, will attempt to end the post-1990 deflationary spiral that has gripped the Japanese economy. These policies, known as “Abenomics,” will attempt to encourage private investment through a more aggressive mix of monetary and fiscal policy. “Abenomics” aims to end deflation by targeting a 2% inflation rate, as well as to increase fiscal spending by 2% of gross domestic product, or GDP. This level of government spending is expected to raise the 2013 deficit to a whopping 11.5% of GDP in 2013—higher than that of the US budget deficit after the 2008 crisis, as well as present-day Greece’s deficit (with approximately 10.0% budget deficits).
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.
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.