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Are Japanese equities signaling that the country’s era of deflation is finally coming to an end?
If so, investors worldwide will have plenty to chew over, even if they don’t hold any Japanese assets.
Although the Japanese market has gained from the euphoric global mood since markets hit their euro-crisis lows last autumn, it’s been outperforming lately. Since the start of the year, the Nikkei has jumped 13%, against a 9% rise by the MSCI world index over the same period.
This upward drive has been given additional momentum by the Japanese authorities’ commitment to target inflation by throwing the Bank of Japan into asset purchases. The 1% rate it’s aiming for looks a modest ambition, but set against a couple of decades of deflation, you could forgive investors for saying “good luck.”
Still, the commitment seems strong.
So why should investors without a direct interest in Japan care? Two reasons.
An aggressive Japanese pursuit of inflation will, in effect, put the whole of the developed world solidly on one side of a global monetary battle, with emerging markets on the other. In effect, developed countries, overburdened by debt, are seeking a collective devaluation against the likes of China, Brazil and India in order to regain competitiveness. Because developed economies are battling deflation and shortfalls in aggregate demand and emerging economies are running at capacity, if the latter try to prevent their currencies from appreciating against those in the developed world, they’ll end up importing inflation. Perhaps a lot of it. To one degree or another, all these emerging markets have been battling rising consumer price pressures over the past year or so. This struggle will continue until the developed world has regained competitiveness.
The second is that Japan’s search to end deflation will result in dramatic upheavals in the Japanese government bond market. Japanese government bond yields are effectively as low as they can get, and have been for years. Inflation will decrease their attractiveness, probably triggering a long awaited selloff. For a country with a gross debt-to-GDP ratio likely to approach 240% this year (and rising), that’s a worry. Even netting out the Japanese government debt held by Japanese institutions leaves a ratio of some 140% by the end of this year.
Whether this happens through massive inflation or through some sort of default will be up to the Japanese government.
When the Japanese bond market breaks, there will be ructions, felt the world over. There may well be flows from Japan into other “safe-haven” markets. But, just as likely, holders of U.S., U.K. and German government debt could well start to rethink their positions.
The positive here is that Japanese debt is almost exclusively owned by the Japanese themselves. So domestic inflation and the destruction of the Japanese debt market will represent a restructuring of obligations within the country. In effect, a collapse in JGBs would be a transfer of resources from the old to the young. This could well prove a critically important trigger for Japan’s return to health. If the young stop feeling quite so burdened by the old, they could well start to have families again. Japan’s woeful demographic outlook could tilt again, albeit at the cost of increasing poverty among the old.
In any event, after 20 years of stasis, it looks like things are going to start shifting in Japan again.
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MarketBeat looks under the hood of Wall Street each day, finding market-moving news, analyzing trends and highlighting noteworthy commentary from the best blogs and research. MarketBeat is updated frequently throughout the day, helping investors stay on top of what's happening in the markets. Lead writer Steven Russolillo spearheads the MarketBeat team, with contributions from other Journal reporters and editors. Have a comment? Write to marketbeat@wsj.com.
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