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America 2021, Japan 1987
Because I’m a pessimist by nature, this newsletter usually talks about risks to the downside. But for us cautious types, upside risk can be just as dangerous. For the conservatively positioned, a face-melting rally can really hurt. And there is some reason to think that we might just have one of those in the next few years.
One way to express this possibility is to say the US stock market is analogous to the Japanese market in 1987.
It’s not a perfect analogy, but it’s informative. Here is a chart from Absolute Strategy Research, showing Japanese and US stock prices and price/earnings ratios, at a lag of 35 years:
If you get out of a market when price multiples look crazy — as one might have when P/Es hit 35 in January in ’87 — you can sit there, uninvested, while your imprudent friends become obnoxiously rich.
Ian Harnett of ASR thinks the chart tells a tale of poor Japanese fiscal and monetary policy, which were too easy for too long:
“If you adopt inappropriate monetary and fiscal policy, the risk is that [the excess] doesn’t turn up in CPI inflation first, but in asset price inflation . . . That’s how you suddenly bust all your mean reverting [stock valuation] models. At 35 times earnings you got out because you were three standard deviations from what you had seen before, and it doubled from there.”
Arguing that current policy could well be inappropriate too, he points to a letter in the FT earlier this week from Mervyn King, former governor of the Bank of England, which said that:
“The large monetary and fiscal stimulus injected in the advanced economies is out of all proportion to the magnitude of any plausible gap between aggregate demand and potential supply . . . A combination of political pressure to assist in financing budget deficits, unwise central bank promises not to tighten policy too soon and an expansion of central bank mandates into political areas such as climate change, all threaten . . . a slow response to signs of higher inflation.”
King refers to the “deafening silence” of central bankers on the growth of broad money. To my ears what has been deafening is the mandarins’ silence about high asset prices, ie, about the analogy with 1980s Japan.
But bubbles are complicated things, and we should be careful to check if the Japan analogy is actually helpful. Here I proceed gingerly. I am no expert on economic history. I hope readers will respond to what follows, which is sure to commit errors or simplification, if not other kinds.
The roots of the Japanese bubble are often traced to the 1985 Plaza Accord, an agreement among Japan, the US, the UK, France and Germany to depress the value of the dollar, whose strength had led to trade imbalances and was killing (among other things) the US automotive industry. The subsequent rise in the value of the yen drove Japan’s export-driven economy into a recession.
Coming out of the recession in early 1987, however, Japan started to roar: strong real gross domestic product growth led by heavy fixed investment, a still strong but stabilising currency, lax monetary policy and a growing money supply, and consumer price inflation that was edging higher but did not look dangerous, all coincided.
The Bank of Japan grew restless about inflation before long. But there was a strong focus on keeping interest rates low to ensure that the yen did not appreciate again. And the stock market crash of 1987 scared central bankers worldwide into keeping rates lower for longer. Japan did the same, despite its strong economy. The central bank did not raise rates until 1989, by which time asset prices were at heroic peaks.
Here are charts from an excellent paper about the bubble by BoJ economists Kunio Okina, Masaaki Shirakawa and Shigenori Shiratsuka, showing the strengthening yen against rate policy:
The loose monetary policy clearly did not cause the bubble by itself. Aggressive bankers, deregulation, euphoria and other factors had their role to play. But the BoJ economists conclude that maintaining low rates up to the end of 1989, despite official concerns about inflation, was key:
“The most important point in considering the relationship between the emergence of the bubble and monetary policy is that as low interest rates were maintained under economic expansion, expectations that the then current low interest rate would indefinitely continue proliferated after a certain point in time, which led to strengthening the effects of [other] mechanisms on the rise in asset prices.”
This picture (as well as the authors’ comments about public and political pressure for low rates) chimes with the US situation now, where long-term inflation expectations remain restrained, helping to justify high asset prices.
For Harnett, the point is that Japan used easy monetary policy to depress the yen, which it could not possibly do, and trouble followed. This time around in the US, monetary policy is being used to make the US economy more equitable. It is the wrong tool again. Economic shocks help to justify both policies. In Japan in the 1980s, the shocks were the Plaza Accord and the 1987 crash. In the US today, it is the pandemic.
Albert Edwards, strategist at Société Générale, summed up the point nicely to me:
“In the same way the strong currency allowed Japan to pursue a changed monetary policy, the pandemic shock has allowed policymakers to cross the Rubicon into monetary-fiscal co-operation. The pandemic allowed a regime change to occur, in the same way the Plaza Accord did.”
Pelham Smithers, who leads a London research shop that has long focused on Japan, adds an important point. It was easier to tolerate high asset prices in the late ’80s because, as in America today, many companies were producing genuinely excellent results:
“The summer of 1988 is when things like steel companies went through the roof in Japan. It wasn’t a pure commodities boom, it was companies that were doing really well in the real world. They were raising prices, increasing volumes and not facing rising costs . . . businesses that were suddenly making a lot of money were on the rise. The economy had recovered, the yen was weakening and these were fixed-cost businesses, a triple-whammy.”
One disanalogy is the bond market context. In Japan in the 1980s, long-term bonds had higher yields than stocks (higher than stocks’ earnings-price ratio, that is). Here is a chart from Okina, Shirakawa and Shiratsuka showing what they call the yield spread, or earnings yield subtracted from the long-term bond rate:
That spread in the US now is even lower than it was in Japan in 1987. In fact it is negative. Earnings yields are low, but higher than long Treasuries. That might suggest, to a bullish mind, that US stocks have even further to run than Japanese stocks did.
We may indeed want to plan for the possibility of Japan-style asset price melt-up. It doesn’t seem like the central forecast, but it doesn’t seem impossible, either.
One good read
My colleagues Harriet Agnew and Laurence Fletcher had an excellent piece last week on the legacy of the hedge fund manager Julian Robertson, who had proven especially adept at spotting talented analysts, many of whom have gone on to found their own funds.
What makes a good money manager? Most people think it’s brains, which are indeed necessary. But lots of smart people are lousy fund managers. A notion that keeps coming up in the Robertson piece is competitiveness, which I think is actually rarer than high intelligence. Everyone likes winning, but a burning hatred of losing is scarce, and hard to maintain.
Some years ago I spoke to an executive at a famous family office about manager selection. He said that as soon as hedge fund chiefs got seriously interested in philanthropy, it was time to divest. It showed the competitive edge was slipping. I think he had a point.