Now that the drama of postal reform has ended, investors are focused on market trends. What the will Bank of Japan (BoJ) do, and when? How will bond markets respond? What will be the side effects on forex, equities, and real estate
The BoJ : The Gradual, Mild Path
Recent Bank of Japan (BoJ) comments have been hawkish about tightening policy. However, as my colleague Takehiro Sato points out, the distinction between the zero interest rate policy (ZIRP) and quantitative easing (QE) is crucial. ZIRP is the policy of pushing the overnight call rate to zero. This is accomplished by providing the full Y6 trl of required reserve levels for banks. QE is an additional policy to supply reserves well above the required level. Currently, the BoJ reserve target is Y30-35 trlThus, exit from ZIRP involves two policy changes. First, the BoJ must exit from QE. This can be done either suddenly or in stages. Second, the BoJ must exit from ZIRP itself. I believe that the timing and extent of both moves will be gradual. The first steps toward reducing QE are likely to come in spring 2006. Thereafter, I see the end of ZIRP itself in spring of 2007, with only a modest rise of the overnight rateThe balance of risks and losses favors the gradual, mild path. If the BoJ takes a sudden aggressive path and this turns out to be wrong, then the losses would be severe. Indeed, a mistake might even trigger legislation to reduce BoJ independence. In contrast, if the BoJ takes the gradual, mild path, and this turns out to be wrong, inflation would accelerate. However, if Japanese inflation rises from 0% to 1% or even 2%, the loss to the economy would not be great. With such a balance of risks and losses, it seems only rational for the BoJ to adopt a gradual, mild path
JGB Outlook
Even with the BoJ on a gradual, mild path for policy change, the bond market will have to contend with other forces. The two key ones are economic recovery and global yield trendsThe economy remains on track for an investment-driven recovery. Machinery orders have been strong, and the aging of the population implies increasing needs to substitute capital for labor. Foreign demand remains a concern. Should the US falter, and bring weakness to China as well, then Japan would suffer both direct and indirect effects. However, the recent weakness of the yen should help cushion any weakness in foreign demandConcerning global yields, ten-year Treasury yields have returned to the 4.4% level, but a more aggressive Fed implies that the long end should see further yield increases. Correlation between US and Japanese yields has been consistently positive for the past several years. Hence, it is reasonable to expect higher US yields to put upward pressure on Japanese yieldsThe fiscal situation remains serious, but at least the road to fiscal reform has fewer obstacles, in the wake of PM Koizumi’s landslide election victory. Moreover, strong demand for bonds among Japanese financial institutions will likely constrain yield increases. Loan demand remains weak, and insurance companies still have liabilities far longer in duration than assets, and hence need to buy long-dated bondsThus, JGB yields are likely to rise over the next two years, but gradually and modestly. I believe that a break through the 2% threshold is possible by mid 2006, in light of stronger growth and the return to positive inflation. A move above 2.5% is not likely, in my view
Whither the Yen
For some months now, investors in Tokyo have been scratching their heads: If foreigners are buying so many Japanese stocks, then why is the yen weakeningThere are two explanations. The first is that the normalization of the Japanese economy has made domestic investors less risk-averse, and hence more willing to invest abroad. The second is the carry trade. With the overnight rate in Japan at zero, it is only natural for investors to borrow large amounts in Japan, convert to dollars, and invest in high yielding foreign assetsThe first factor is likely to continue. The second is more problematic. So long as ZIRP remains, the carry trade will continue. However, as quantitative easing is cut, some of the carry trade may have to be unwound. If so, then the part of yen weakening may disappear as well
The Equity Outlook
The future of equities boils down to earnings growth and valuations. My colleague Naoki Kamiyama has set a 16,000 target for the Nikkei Index at end-2006, a 20% rise from current levels. This level is justified by the 15% earnings growth we now see in FY06, and a further 10% in FY07 — without P/E expansion. Moreover, there could be a decline of the equity risk premium, as deflation ends and reform accelerates
Real Estate
More investors are seeing real estate as a respectable asset class, and are searching for sub-classes as well. Japan Real Estate Investment Trusts (JREITs) are extremely popularWhile real estate is now back in vogue, there is no bubble. The rise of real estate prices remains concentrated in the centers of major cities, while prices in suburban and ex-urban areas are still falling. These trends are likely to continue, in my view. They suggest that investors have learned the lessons of the bubble, and are valuing property on a discounted cash flow basis.
By Robert Alan Feldman, Morgan Stanley economist, as published on the Global Economic Forum