Wednesday, April 3rd, 2013

Let’s pretend

For the second time in a month this blog is about Japan. The reason is that it now ranks fourth in our table of 44 countries, measured in terms of the probability of superior risk-adjusted returns relative to a world index. This is highly unusual. The average data for the last 17 years show Japan in second last place, with only Portugal behind in it.

Before anyone gets carried away and starts talking about a new Meiji restoration (cf. the FT yesterday) we should point out that we have been here before. The country hit number two in our rankings in 1998, 2005, and 2011, and even managed the top slot in 1999 and 2008. But the position was never maintained, and these brief rallies were always followed by periods when it was continuously in the bottom five for months on end.

Our crystal ball is no better than anybody else’s. There is no certainty that Abenomics will work, or indeed that the new government will consistently follow this policy mix. So the rest of this blog is devoted to a simple thought experiment. What are the implications for other global equity markets if it really is different this time?

The first and most obvious comparison is with the Eurozone. We know what happens to a developed country if it adopts an inappropriate policy mix in the wake of a banking and real estate crisis, and allows large parts of its industrial base and workforce to become uncompetitive because of currency appreciation. What happened to Japan from 1996 onwards could already be happening in the Eurozone.

But there may be implications for emerging markets equities as well. Historically, the two main attractions of this asset class for US investors were the faster growth in GDP and the relatively low level of correlation with US equities. Over time growth rates have fallen and the correlation of returns has risen. Japan now has lower correlation with the US than all of Latin America and much of Asia. If (and it still is if) Japan’s nominal growth rate really does accelerate, it would offer an effective and profitable means of diversification for US investors. That really would be different and would attract US money away from emerging markets as well as the Eurozone.

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