Let’s start with a question. If Japan has rock bottom risk-free rates, shouldn’t its companies command higher multiples? Shouldn’t Japan be a global hub of innovation - because low rates and structural deflation allow for investment in growth?
To the first question - Japanese companies certainly do not command higher multiples. Japan’s TOPIX Index has a forward PE ratio is 12, while it has a 30-year bond yield of 1.4%. The MSCI US Index in the meanwhile has a forward PE ratio of 14 with 30-year yields of 3.9%. In other words, Japanese companies do not enjoy a better fundraising environment simply because the Japanese government has artificially suppressed yields. Japan has even gone so far as to explicitly buy equities - owning 50% of outstanding ETFs.
The things that US and most recently UK investors seem to pine for - extreme, even “unlimited” support for debt markets - have not really worked for Japanese capital markets.
Why would this be?
QE in Japan ended an age of economic dynamism. Corporations were not allowed to fail. “Financial stability” became an excuse for lost generations, declining productivity, and a general sense of hopelessness. Japanese banks, and most recently Telecoms (Softbank) have been notorious over the years for wasting government guarantees not on investing in domestic innovation, but on rampant speculation that blows up. Over and over again.
The Credit Suisse saga we keep reading about has been going on in Japan for nearly 35 years.
Softbank is the technology era version of the banking sector - with its founder kicking not into gear for both of the major tech bubbles of the last 25 years, blowing up both times.
Rampant speculation stifles dynamism and innovation. It makes people cynical. The downdrafts drive a culture of risk aversion and saving which ultimately translated in Japan to a deflationary impulse - largely in part due to a culture of immigration restrictions and implicit (if not explicit) racism.
This should all seem very familiar to a new generation of US investors who got caught up in a flurry of “innovation”, seeing many entrepreneurs get extremely rich on secondary equity offerings, not producing anything.
A hyper-merger of the government and capital markets results in periodic manic gambling, and margin calls on the edges. With corporate bloat and hierarchy in the middle.
Reading the above - it’s hard not to see parallels to the US, culturally. Rampant speculation breaking incentives, driving droves of Quiet Quitting (otaku). Financial bubbles that benefit the cynical at the expense of average people. Corporate clown cars like Boeing too big to fail in the name of employment, receiving endless and ever-expanding government handouts to stay in business.
Somewhat ironically- avoiding the Japanese economic model was a frequent mantra of US central bankers, used to justify expanding QE to prevent deflation. And yet here we are with seemingly many of the downsides of Japanese culture, with none of the affordability that has come with decades of deflation in Japan.
Quantitative easing was an emergency measure that got over-used. Capital markets became addicted to it.
The Deflation which justified QE was not the same type of deflation in Japan. Deflation in the west was driven by 3 unsustainable factors - namely 1] the exporting of production to China. This made things cheap but was unsustainable. Now the Chinese are quite skilled consumers competing for goods, as well, and also a geopolitical rival. This has military costs as we are now seeing both with protectionism and China’s support of Russia in its actions against Ukraine. 2] investing in uneconomic tech companies such as Uber which grew thanks to slashing prices. 3] investing in uneconomic energy production via the fracking boom. The boom-bust cycle that resulted is responsible for the mantra of “capital discipline” we are seeing now. And economic shortfalls that have resulted bring the dirtiest of energy back onto markets, increasing long term inflation via health harms and exacerbating climate change.
Japanese deflation was a product of 1] excessive immigration restriction coupled with declining birth rates 2] a culture of periodic speculation, crashes and corporate inefficiency 3] a love of cheap prices, efficiency and a desire to save on small things in life (something that might even be said to be a big plus of Japanese culture!).
Two points - first. All of the Japanese deflationary elements are still in place. This is largely reflected in market Japanese inflation expectations of sub 2%. All three of the US deflationary elements are no longer in place. So outside any cultural parallels, it’s a vastly different situation to a country running QE. This is why central banks are so unwilling to restart QE. We bear no resemblance to Japan.
And the second point. It’s worth observing that Japanese deflation really got kicked off with a catastrophic asset crash. And you could certainly imagine a world where that happened in the US or the world.
Stocks reset to 10x earnings because it turns out Xi consolidates control -China bans the iPhone, cloud computing was a shitty up-sell to On-Prem which just raised cyber security costs, electric vehicles were a giant grift cooked up by a con-man with minimal mineral requirements completely out of whack with geological feasibility. Venture capital and PE were just ponzi models built on declining rates, and upselling illiquid holdings into rising liquidity and valuations. People realize it was all bullshit and seeing the “smart people” who have already cashed out just leaves a sinking feeling, absurdity, lacking motivation. r/AntiWork. Then back-to-back right-wing and left-wing nationalist Presidencies. Trump. AOC. Anti-consumerist movements.
And I suppose – in this “We become Japan through an asset crash” world, when you’re asking “who the marginal buyer of treasuries” is? Just take a look in the mirror. Or in your parents’ retirement account. Full scale liquidation of equities sold on completely false pretenses and irrational historical equivalencies. Flight to bonds in declining economic dynamism. If people want capital preservation, not inflation protection, you don’t need a central bank to do the marginal buying of treasuries. People will be begging for Tbills with stocks down 40%. New Treasury Direct issuances will drop like the new Star Wars movie.
But enough bear porn. Consider the opposite
What if ARKK imploding, crypto dropping, and all these ponzi SPACs unwinding is actually a great thing? The invisible hand of capitalism backhanding those who are unworthy. What if the US kicks the crap out of Russia through its proxies? What if Xi loses control because it turns out the Chinese Boomers lived through Mao, and really really didn’t like that. And that they worked their asses off their entire lives to avoid that for their children. Then Chinese Democracy. A reset with the two great powers. The Eagle and the Dragon high fiving at the Costco Shanghai. $1.50 Hot Dog Bao Abomination is created. It is delicious. The French are disgusted but eat that crap anyways.
The UK and Canada start outgrowing everyone because of their extremely easy immigration plans. Others feel the need to copy it. The highly skilled Russians who escaped Putin’s regime kick into high gear, writing horrendous amounts of AI code fully decked out in Adidas track suits. A new generation of entertainment emerges from the rendering capabilities. Starlink and global internet make billions of people into productive earners. What’s Tesla? Ah right the collateral for Twitter - the X app everyone uses as their crypto wallet.
This bull case has a name as well. “The Great Rotation”. Suddenly we’re growing so fast, debt problems go away. Debt becomes an instrument for yield instead of a policy tool.
And I think that’s the key litmus test. And that’s the way I understand bond market liquidity, and rates volatility.
The bull case and the bear case are completely different. There’s a world where central banks lose control, the US loses its reserve currency status, totalitarianism is ascendant and volatility reigns. Crashes periodically halted by money printing. Insane FX volatility. 2022 is a sneak preview. Then there’s a world where democracy and freedom prevail. Putin and Xi are studied in history books as historical aberrations in the direction of a long-term global prosperity.
You can make compelling arguments for both cases, and different asset classes tell different stories. Bond volatility, illiquidity and BOE pension crises foreshadow darkness. But US equities parabolic against Chinese, bolstering the dollar with higher rates, say the opposite.
I think in a simplified sense - the happy case looks like: “2-year rates stay where they are or drop slightly, and the yield curve steepens. Stocks chop around but the Fed is allowed to do its job crushing inflation. Dollar sells off quite a bit (EUR back to 1.20) while Gold, Oil and Bitcoin also underperform.”
The unhappy case looks like “rates make blow out moves frequently. yield curve control implemented. Dollar moons, forcing multiple sovereign defaults. Russia annexes large parts of Ukraine. Far right European politicians align with Russia. China comes in as the new power and aligns world against US. Immigration controls implemented globally. Gold, commodities, btc parabola after the margin call is done.”
I think we find our way to “Japan”, and associated QE-restarts, and fed pivots only in the unhappy case. So perhaps be careful what you wish for.
I’ll end with some selections from Superfrog Saves Tokyo - one of my favorite Murakami Stories that feel pertinent to our spiritual war against the Great Worm of Global Despair.
“Yes, you were. You did a great job in your dreams. That’s what made it possible for me to fight Worm to the finish. I have you to thank for my victory.”
“How did we manage to defeat Worm? And what did I do?”
“We gave everything we had in a fight to the bitter end. We—” Frog snapped his mouth shut and took one great breath. “We used every weapon we could get our hands on… Worm tried to frighten you away with phantoms of the darkness, but you stood your ground. Darkness vied with light in a horrific battle, and in the light I grappled with the monstrous Worm. He coiled himself around me and bathed me in his horrid slime. I tore him to shreds, but still he refused to die. All he did was divide into smaller pieces. And then…”
Frog fell silent, but soon, as if dredging up his last ounce of strength, he began to speak again. “Fyodor Dostoevsky, with unparalleled tenderness, depicted those who have been forsaken by God. He discovered the precious quality of human existence in the ghastly paradox whereby men who have invented God were forsaken by that very God. Fighting with Worm in the darkness, I found myself thinking of Dotoevsky’s ‘White Knights.’ I…” Frog’s words seemed to founder. “Mr. Katagiri, do you mind if I take a brief nap? I am utterly exhausted.”
“Please,” Katagiri said. “Take a good, deep sleep.”
“I was finally unable to defeat Worm,” Frog said, closing his eyes. “I did manage to stop the earthquake, but I was only able to carry our battle to a draw. I inflicted injury on him, and he on me. But to tell you the truth, Mr. Katagiri…”
“What is it, Frog?”
“I am, indeed, pure Frog, but at the same time I am a thing that stands for a world of un-Frog.”
“Hmm, I don’t get that at all.”
“Neither do I,” Frog said, his eyes still closed. “It’s just a feeling I have. What you see with your eyes is not necessarily real. My enemy is, among other things, the me inside me. Inside me is the un-me. My brain is growing murky. The locomotive is coming. But I really want you to understand what I am saying, Mr. Katagiri.”
“You’re tired, Frog. Go to sleep. You’ll get better.”
“I am slowly returning to the murk, Mr. Katagiri. And yet…I…”
Frog lost his grasp on words and slipped into a coma. His arms hung down almost to the floor, and his big, wide mouth drooped open.