At SSQ Investment and Retirement, the fund development team responsible for monitoring the financial markets and segregated fund managers is constantly on the lookout for events that may have an impact on the performance of ASTRA Funds and the returns of your clients’ portfolios. In this context, the team would like to share an article of interest prepared by AlphaFixe Capital, the manager of the AlphaFixe Bond Fund included in the ASTRA Strategy and Celestia Funds.

Headquartered in Montreal, AlphaFixe Capital is a fast growing bond manager with more than $2 billion under management. Correlations between global financial markets are increasing, which implies that the monetary policies of foreign countries have an impact on the Canadian credit market, AlphaFixe Capital must therefore be continuously well informed. As such, the manager is a great source of information on the characteristics and potential effects of Abenomics, Japanese Prime Minister Shinzo Abe’s new economic model.

AlphAFixe CApitAl reFleCts on JApAn’s new eConomiC model

the empire striKes BACK

The Bank of Japan announced an unprecedented monetary injection to revitalize its economy

When he ascended to the throne on January 7, 1989, the current Emperor of Japan, Akihito, had probably never imagined he would witness the bursting of the real estate and stock market bubbles that led his country into economic collapse.

Since then, for the past 24 years, 18 prime ministers have come and gone, all helpless in the face of a gloomy economic climate that continues to this day. Among these prime ministers is Shinzo Abe, who despite a dismal first term as prime minister from 2006 to 2007, was once again elected in December 2012, running on a platform promising to get the country back on its feet again. His program is bold and is based on three components: fiscal, monetary and structural.

But has it come too late?

ABenomiCs: 4x2=UnCertAintY!

To boost Japan’s ailing economy and tackle the problems of deflation and debt, Mr. Abe is placing his bet on the number two. With the help of the new governor of the Bank of Japan, Abe’s plan aims to bring the country’s inflation rate to 2% within 2 years. To achieve this, Governor Kuroda will double the country’s money supply by purchasing monthly ¥ 7.5 trillion (US$75 billion) in bonds with the intention to also double the average maturity of assets that the monetary authority will hold. The monetary authority will annually purchase the equivalent of 19% of the country’s GDP, compared to 6.5% for the United States, whose monetary policy is already considered aggressive.

The plan is especially bold in the eyes of the Japanese and has sparked strong reactions. Since the election of Abe’s government on December 16, 2012, the stock market index has jumped by 40%, while the yen has depreciated by nearly 15% as at July 31, 2013. The stock market gain has also led to growing consumer confidence, which in May reached its highest level since 2007. Propelled by exports and consumer spending, the real GDP has risen by 3.8% in annualized terms in the first quarter of 2013.

At first glance, everything seems to be working, but when you scratch the surface, you find that the situation is deteriorating and any improvement may be short-lived. If you take into account the price variation, the (nominal) GDP increased by only 2.5% in the first quarter. Because of deflation, Japan’s economy is now 4% under what it was in 1995. For Japan, it’s the nominal GDP that is primordial because it dictates the country’s ability to collect tax revenue and repay its astronomical debt, which will reach more than 240% of its GDP this year.

At first glance, everything seems to be working, but when you scratch the surface, you find that the situation is deteriorating and any improvement may be short-lived.

strUCtUrAl proBlems: AGeinG popUlAtion

Advocates of the Abenomics plan hope that the monetary injection will help the stock market indices go up and thereby encourage companies to invest and households to spend their capital gains. More money in circulation also means a depreciation of its value, and consequently, the opportunity to increase Japan’s exports, create jobs or raise current salaries.

But the monetary experience of the Bank of Japan should meet with strong opposition. It is not a secret that the demographic situation in Japan is grim. The population is ageing rapidly and the country has one of the worst birth rates in the world. This means fewer workers in the future will be there to pay down debt and support health care and social services, demand for which is expected to explode. Large-scale immigration could alleviate some of these problems, but Japan remains a country closed to foreigners with only 1.5% of its population being of non-Japanese origin. An ageing population is also a population that consumes less. In fact, the level of household consumption in current currency is now equivalent to what it was at the end of 1996.

Population (in millions) Population (in millions)Age group

Japan 2013 WomenMen

Dec 94 Dec 12June 99 Dec 03 June 08

Nominal GDP Real GDP

JApAn’s reAl And nominAl Gdp

demoGrAphiC sitUAtion in JApAn

CUrrenCY mUst Be deVAlUed: FoCUs will Be on ForeiGn trAde

Given this inertia in domestic demand, Japan must turn to foreign trade as a source of economic growth and therefore seize market share in South Korea, China and Germany. Some Asian countries have already reacted to the depreciation of the yen by reducing their key lending rates in order to weaken their own currency.

But one of Japan’s biggest competitors in the world is Germany with its high-tech and automobile industries. How will “Deutschland” react to this currency war when over 30% of its GDP is exported outside the eurozone? It should not be forgotten that Europe’s problems have not evaporated, they are simply buried under a pile of cash. Heading to the polls in September, Germany will want to maintain this source of growth.

Since Japan cannot generate inflation internally, it can import it using a weak currency. Except that imports represent only 18% of the nominal GDP. To drive inflation up from -0.5% to 2%, the currency must depreciate considerably every year. Several countries will oppose to this type of policy in the long term.

FisCAl poliCY: And whAt iF it worKs?

Knowing that there is always a lag between the implementation of monetary policy and its effect, Shinzo Abe also announced a fiscal stimulus of up to ¥10.3 trillion (US$100 billion) or 2% of the nominal GDP. According to the Ministry of Finance, the country is heading towards a deficit of 9% of its nominal GDP this year. The effectiveness of debt to stimulate the economy completely evaporated during the last decades. During its heyday (1980-1989), Japan’s economy grew by ¥1.09 for each yen of additional debt. Today, this ratio is negative, as if it isn’t enough to put gas in the tank__you need to make sure that the engine runs well and that the structure is solid. If leaders want to slow the progression of the country’s debt ratio, the economy must grow in nominal terms at a rate higher than the deficit.

Mr. Abe does not rely solely on economic growth and inflation to improve the government’s revenue. His program also includes raising the sales tax from 5% to 8% in 2014, and then to 10% in 2015. It is a reckless proposition for a government that seeks to stimulate consumer spending. The last time the government raised the sales tax, back in 1997, the economy quickly fell into a recession.

strUCtUrAl ChAnGes: A lonG Uphill ClimB

The leaders at Loto-Québec were surely inspired by the Japanese labour model when they designed the “gagnant à vie” lottery [win for life]. It is virtually impossible for a business executive in Japan to dismiss a full-time employee, even in a recession. It is no coincidence that the unemployment rate stands at only 4.1%. In fact, during the last recession, from December 2007 to June 2009, the U.S. GDP shrank by 4.7%, which forced business leaders to cut the workforce by 4.3%. Meanwhile in Japan, employment declined only by 2.7% in response to a GDP contraction of 7%! Over the years, companies have found themselves with a surplus of employees for the amount of work to be done. This environment is not conducive to wage increases, which also feeds the country’s deflationary circle. The reforms announced on June 5, 2013, did not tackle the problem of lifetime employment.

¥

1.5

1.0

0.5

0.0

-0.5

1.09

0.15-0.08

1980-1989 1990-1999 2000-2012

Y

YY

VAriAtions in the nominAl Gdp For An AdditionAl Yen

oF pUBliC deBt

Trade liberalization is also part of Abenomics. The new government is trying to enhance competition in the agricultural industry, pharmaceuticals and electricity. In addition, it began talks on the country’s participation in the Trans-Pacific Partnership Agreement, a free trade agreement that aims to integrate the economies of the Asia-Pacific region. All in all, these measures will enhance competitiveness, and some industries will lose their pricing power, which makes for an environment more conducive to lowering prices than creating inflation!

whY is JApAn so importAnt now?: no more FUndAmentAls

The performance of financial markets is not based on any fundamentals. For the first seven months of the year, the U.S. and Japan stock exchanges produced returns of 20% and 33% respectively. These performances do not fit the pattern of global growth. During the same period, the Chinese stock index fell by 10%, while that of developing countries (MSCI Emerging Markets) dropped by 9%. Moreover, commodity prices were down 4%.

In times of economic turmoil , these indices normally get the investors’ support. Fluctuations in the financial markets are more influenced by the decisions of central banks, monetary injection and rapid movements of capital by investors who borrow in depreciated yen to invest in markets offering higher returns. Japanese households will benefit little from the rise of Nikkei, as only 20% of them are shareholders __the wealth effect is likely to be imperceptible.

how will this end?: BAnzAi!

This popular expression used now in Japan as a way of congratulating someone, was first used during World War II by the Japanese kamikazes before crashing into an enemy target (ship). It’s somewhat this feeling you have when analyzing the economic situation in Japan.

The country desperately needs nominal growth to curb its debt. There are two options to achieve this__real growth or inflation. Several obstacles limit the first option. These include the ageing population, inflexible labour market, small investment opportunities and limited fiscal stimulus. A good portion relies therefore on exports through weak currency, but most countries take this route, which restricts the chances of Japan’s success. And if a miracle should happen and inflation reaches its target of 2%, then bond yields should increase, resulting in losses to bondholders such as banks, insurance companies and pension funds. These entities could be forced to reduce their positions, thus increasing the upward pressure on interest rates, which would slow economic activity.

All in all, both options offer the same result: more intervention by the Bank of Japan to further stimulate the economy or simply slow the interest rate hikes to avoid making public finances and the current situation even worse.

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