Japanese Stock Market Bust

by Peter Schiff: Tapering
the Taper Talk

The Japanese
stereotype of excessive courtesy is being confirmed by the actions
of prime minster Shinzo Abe who is giving the world a free and timely
lesson on the dangers of overly accommodative monetary policy. Whether
or not we benefit from the tutorial (Japan will surely not) depends
on our ability to understand what is currently happening there.

For now most
economists still believe that Abe has stumbled upon the magic elixir
of economic revitalization. His commitment to pull his country out
of the mud by doubling the amount of yen in circulation, and raising
the nation’s official inflation rate to 2%, had conferred rock star
status on the formerly bland career politician. But just one year
after his first critical raves arrived, the audience is heading
for the exits. As it turns out, the Japanese miracle may be a simple
tale of confidence easily gained, and just as rapidly lost.

In many ways
the 75% nine month rally in the Nikkei 225 (that began when Abe
was elected prime minister in September 2012), and the subsequent
crash that began on May 22, is not all that different from the turbocharged
rally, and spectacular crash, that occurred in technology heavy
Nasdaq more than a dozen years ago here in the United States.

At the time
that Pets.com (the company behind
the iconic Sock Puppet) made its IPO, other high flying tech stocks
had racked up 1000% gains. While investors scratched their heads,
pundits offered reasons why common sense no longer applied to the
new economy. We were told that valuations, revenue and profits no
longer mattered. And to an extent that now seems absurd, the investing
establishment bought into the insanity. But then a funny thing happened,
investors woke up and realized that they had nothing but a handful
of magic beans that couldn’t grow a beanstalk. When the fog lifted,
stocks plummeted…Wile E. Coyote style.

This time around
investors in the Japanese market were similarly deluded by fairy
tales. Leading economists told them that Japan could cheapen its
currency to improve trade, use inflation to create real growth,
increase prices to encourage spending, and drastically increase
inflation without raising interest rates. In short, monetary policy
was seen as substitute for an actual economy.

Initially at
least the economic data seemed to confirm the success of Abe’s program.
The leading indicator was the yen itself, which dropped like a stone.
Given the widely held view that a weak currency is the key to economic
success, the 25% decline in the yen was welcomed as good news. Soon
thereafter, the inflation that Abe so eagerly sought began to materialize
in various sectors of the economy. When the Nikkei reacted positively
to these developments, momentum traders from around began to take
notice, thereby creating self-fulfilling prophecy.

But it’s no
great trick to weaken a currency. Any two bit economy could accomplish
that objective. For a nation like Japan that imports nearly all
of its raw materials it was inevitable that a drastically cheaper
yen would to push up prices. However the rest of the plan, the part
about surging exports and growing economic activity, has been much
harder to achieve. In fact the data has been downright disheartening.
The plunging yen has failed to reverse Japan’s weakening trade balance
which has declined for 28 straight months. The trend finally sent
Japan into an overall trade deficit 10 months ago for the first
time in 30 years. The latest data confirms that while the yen value
of exports has increased, actual trade volume has fallen.

While the broad
economic data failed to impress, economists and investors were nevertheless
hopeful that Abenonmics would eventually work its magic. But recently
the bottom has fallen out in a way that should have surprised no
one, but somehow managed to do just that. Beginning in April Japanese
Government bonds began to sell off sharply. Previously, the Japanese
government could borrow funds for 10 years at just 36 basis points.

The truth is
that the sub 40 basis point yield on Japanese Government bonds was
the most important data point for their economy. At those levels,
Japan needed to spend 25% of its tax revenue to service its outstanding
debt. While that figure is high, most it is manageable given Japan’s
high savings rate. However, with a national debt that exceeds 200%
of GDP, the Japanese government could quickly become insolvent in
the face of higher debt service costs. If rates on 10 year debt
were to ever match the 2% of their inflation target, more half of
total tax revenue would be needed to service debt payments.

But the central
premise of Abenomics seems to be that the Bank of Japan could push
up inflation to 2% without raises the rates on long-term debt. To
do this one would have to assume that bond investors would accept
negative interest rates, even while a falling yen was eating away
at principle and returns on alternative investments would be expected
to be more attractive. Such an outcome is not consistent with human

As a result,
in late May a strong sell off in Japanese government bonds caused
yields to nearly triple to almost 100 basis points on 10 year debt.
And while one percent doesn’t sound like much, it was the rapidity
of the ascent that got everyone’s attention. This grim, but very
simple, reality seems to have hit Japanese stock investors with
a panic unseen since Mechagodzilla took aim at Tokyo. Knowing that
even moderately higher rates could counteract any economic gains
made by stock market or export growth, the faith in Abenomics has
seemed to evaporate almost overnight. Sounds a little like the dot-com
bubble, doesn’t it?

Any more rapid
escalation in Japanese bond yields should tell us that quantitative
easing and growth through devaluation is a cul-de-sac that should
be avoided. Japan should be our canary in the coal mine. In the
meantime, the drama in Japan is diverting attention away from more
important shifts in Asia, more of that in our latest newsletter.

27, 2013

Schiff is president of Euro Pacific Capital and author of
Little Book of Bull Moves in Bear Markets
and Crash
Proof: How to Profit from the Coming Economic Collapse
. His
latest book is
Real Crash: America’s Coming Bankruptcy, How to Save Yourself and
Your Country

© 2012 Euro Pacific Capital

Best of Peter Schiff

This article originally appeared on: Lew Rockwell