NAB Morning Call

Weekend Edition: Japan’s Inflation Revolution

Friday 26th July 2024

Please note this communication is not a research report and has not been prepared by NAB Research analysts. Read the full disclaimer here.

Things are changing in Japan. After decades of not much happening, suddenly everything is happening. Core inflation is up to 2.6%, the Yen is the weakest in a long time, the stock market has hit highs not seen since the eighties, and the BoJ has moved interest rates into positive territory. It all points to a win for Japan according to Harry Ishihara, a macro strategist contractor for Macrobond and Japan Exchange Group. Suddenly companies feel enabled to raise prices and offer higher wages, helping increase margins and drive investment. He calls it Japan’s Inflation Revolution. But will it last? Was this the shot in the arm the economy needed, and how much is being driven simply by a weaker Yen. What’s to stop that weakness being eroded and Japan’s competitiveness diminished? Harry provides some very useful insights into what’s driving the value of Japan’s currency and why a weaker Yen could be here to stay.

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Duration:: 27m
Broadcast on:: 26 Jul 2024
Audio Format:: mp3

They've got inflation now but they're one of the few places in the world that's actually been craving it. So how does that change things for Japan? Our guest this weekend sees it as a bit of a godsend, he's calling it Japan's inflation revolution and the economy is only looking up from now, probably why the share market has been doing so well, that's this week. The Morning Call from NAB, with Phil Dobby, the weekend edition. Well Japan's core inflation rate, as we were talking about a bit on the Morning Call, is on the rise, 2.6% in the June numbers, following a 2.5% rise in May. For most of this year, the yen has been losing value against the US dollar, we went from 140 yen to the dollar at the start of 2024 to over 160, although that has changed a little bit this month. The stock market hit new highs recently, going beyond the level, setting that bubble back in the 1980s. So what is going on in Japan, a country where interest rates have been negative for the last day years, and only just got above that in March this year. Any further increments are looked at in terms of 10 basis points, not 25 or even 50, that would be accustomed to elsewhere. So why is Japan out of kilter with the rest of the world when it comes to monetary policy? Why is their economy so different? Why is their central bank so cautious? And what's changed there from the halcyon days in the 80s when we were wondering whether it was going to be Japan, not China, that would be challenging in the US as the world's leading economy? I did hear one commentator recently saying that Japan has lived in the year 2000, since the 1980s. Well ahead of the pack back then, but it simply hasn't kept up. If that's the case, why is that and what needs to change? And just how much can the central bank or the government do about that? And the questions we like to ask on this podcast, of course, what does all this mean for markets? Well, Harry Ishihara believes that the structural change happening in Japan that we need to be aware of. Harry is a macro strategist contractor for macro bond and Japan exchange groupies with me now. So we'll look at the structural change in just a moment, but an obvious first question, why has inflation been so low in Japan for so long, Harry? Thank you. So since the two bubbles burst in the 90s, so the stock market bubble was first in 1990 and then followed by the real estate bubble burst in 1991, basically. And then we were stuck in this like 30 year period of disinflation and deflation and basically Japan lost confidence, but you got to remember, there were like two shocks or multiple shocks in Japan over the period. So like in 1985, we got hit by the Plaza Accord, which hurt our currency, which strengthened our currency and this hurt our exports. And then in 1986, we were hurt by the US-Japan semiconductor agreement, where we had to agree with the US that all the cost structures of our semiconductor companies had to be given up. And I think the US had pricing power over our semiconductor industry. So it was kind of a unfair agreement. And so a large industry got taken out and then Japan had to overstimulate the economy, which caused the two bubbles and then they tried to put a break on it and it caused them to burst. And we were stuck in deflation and disinflation for like about 30 years. Right. And then the consequence of that is that you just don't get growth, do you? If you've not got, if you've not got any inflation, then there's no way you can increase your margins. So less ability to grow so it becomes self-perverted. Exactly. Yeah. And then the demographics set in, so exactly, you're exactly right. Yeah. And then the demographics, an aging population as well, which is huge, a huge population. Yeah. People lost confidence and they stopped getting married and stopped having kids and that hurt the economy over the long run as well. And that also aggravated the disinflation problem. Right. But now, right now, what's happening? Right now. So Japan's inflation revolution has come. And it's continuing. I actually wrote a piece about this last year, I really should update it. But like I said, after like 30 years of fighting disinflation and deflation, the highest inflation in 40 years seems like it's restarted Japan, like turning the key on the car almost. It's sparking innovation because finally, companies can innovate and charge for it. Right. So it's sparking innovation, which is great. It's sparking wage growth, the highest wage growth in like 30 years, two years in a row now. And it's sparking price hikes, which is showing up in hard data, or at least higher soft data, price hikes across the board. And of course, as stocks are a nominal instrument, price hikes lead to higher sales and lead to higher profits and that supports the market. So it's a new feeling. And I thought that was a good title, Japan's inflation revolution, and I really should update it. But I feel it's continuing. Yeah, well, so good that we've stolen it for this podcast, actually, because it's too good to avoid. But why is the central bank trying to curtail it? Or are they the fact that they are just moving in such small movements? Is that just because they want to tread carefully, they're just trying to find the balance? Great. Yeah. That's why they're going so slowly. You know? And they don't want it to be too effective, do they? No, they don't. They want inflation to be stable around around 2%. After 30 years of fighting deflation and disinflation, they want to stabilize at 2%. So they're focused on wage growth, because they're hoping that wage growth will start a virtuous price wage spiral. Yeah. Making stuff, you've got to have people to buy it, so they've got to have more money in their pockets to do that. So what's holding back that wage growth? Is that just a cultural thing that people have got so used to not asking for a wage rise? They'll be fearful of doing it now. Yeah, thank you. So during those 30 years, what Japanese corporates did was basically, instead of laying off people left and right, they kept a social contract intact. And so instead of what they did was everybody took a cut, the whole company did, basically. So that means wage growth was stagnant and inflation was stagnant. How curious why that is, though? Why in Japan, in particular, do we have this situation where wages to stay go up? So there's something called the former BOG governor called the zero inflation norm. I think that was the correct translation. So the zero inflation norm that for many years, during those 30 years of disinflation and deflation, companies and restaurants and hotels, et cetera, they got punished for raising prices to absorb higher costs. Every time that costs went up, they got punished if they tried to pass that on to the consumer. So what consumers would do is they would actually lose that company that tried to pass on the cost, would lose market share immediately. So what they weren't getting punished by the government, what you're saying is the consumer attitude was that if you raise prices, we're going to punish you. And what happened was everybody got smart. And so the most optimal pricing strategy was to keep prices flat, no matter what. And that continued for almost 30 years. And then we got hit by Corona and then the supply shocks. And the BOG actually let inflation go up because they wanted to escape deflation. Right. So it's an opportunity in a way. So is that a change thing now? People accept that prices can go up and companies can start to push prices up. Thank you very much. The reason why they punished the companies was that they didn't see the price hikes as inevitable. But when the consumer thinks that the price hike is inevitable in Japanese, we say, "Shkatanei, inevitable." If it's katanei, then they will accept the price hike. That's it. Well, we're learning so much on this podcast, even rudimentary Japanese, which is fantastic. So that's all good news then, doesn't it? That makes a Japan a huge investment opportunity, as you say it can't be turned back on again. Yeah. Warren Buffett came in. He bought the five trading companies. I shouldn't say trading, I should say it put export companies out of Japan. And yes, the Nikkei did very well over the period. And you know what? Corporate balance sheets look very strong overall. They have record levels of cash on hand, and that's keeping stock buybacks elevated. And business sentiment is also good. Services are near 30-year highs. Manufacturing took a hit from some auto scandals recently, the dash recovery season. And finally, as we were talking about tourism, it's great. First half of 24-year lows. We were talking about just before we came on, before we started recording. Absolutely. Yeah, because all of a sudden, you're great value from that. Yes. First half of 24 was a record. And over tourism is a hot topic here, and it's lead to a push for hotel taxes. You can get a good meal for less than $4 here. So it's almost a steal. I mean, the reason for that, obviously, is the Yen. It was about $100 Yen to the dollar in 2020, well over $150 now. It was $160 a couple of weeks back, which is the lowest it's been since April 1990. So what's driving that? I mean, part of it obviously is the differential between interest rates that, you know, why buy Japanese bonds when the yields are so low. But it is a longer-term trend, isn't it, that's driving this? Yeah. So the week Yen seems to be more stubborn than someone like. The trouble, there's good things and bad things about the weekend. So first of all, it's good for the stock market because the stock market is driven by international investors who focus on Japan's multinational companies who profit from a week or yen. Like all the makers make, maybe a billion dollars for every yen that every yen weakening. So that's the good side of it, I guess. But on the other side, Japan imports like over 80% of its energy and like 70% of its calories, food, right? So a week Yen aggravates cost and really hurts the consumer. So that's the bad side of it. And the Bank of Japan has to do something about it. There's political pressure on the Bank of Japan and there's been recent currency interventions. The currency interventions, a lot of people get this wrong, but that's led by the Ministry of Finance. They oversee currency policy, not the BLJ. The BLJ executes the trades, but it's not, they're not overseeing it. But anyway, so the Ministry of Finance, they have done multiple interventions, which is very rare. And it can only be done when US-Japan relations are good. US-Japan relations basically go in, I would say, like 30-year cycles. It goes from friend or foe, friend or foe, friend or foe, and right now we're in the friend mode. Yeah. But perhaps not for long. No, I think it's for long because the US-China trade war, so like in 2001, when China joined the WTO, Japan became sort of like an economic foe of the US. And China was given the world's factory status. But now with the US-China trade war, now Japan is being realigned as an alternative to China and a US tech ally with Taiwan. Right. So you are the counter to China. So that means it presumably would be relatively Trump-proof if that was the case. So that friendship could last for a while longer than is what you're saying. So I'm curious, though, about the currency. Why we've got a week of yen when you've got such a huge current account surplus. I mean, normally if you've got a current account surplus, that means there's going to be demand for the money that's going to push the currency up. But the exact opposite is happening in Japan. Why is that? Right. Thank you. So I guess I'll have to start with a short definition of the current council. The current account is like an expanded version of the trade balance. Trade balance is, of course, if Japan exports 3 million of cars, imports 1 million, so it's a trade surplus of 2 million. Right? So that's easy. And the current account expands on that by including net flows in interest, net flows in dividends, net flows in reinvested earnings that are generated from direct investments and financial investments. And by direct investments, it's sometimes called FDI. FDI would mean like factories that like Toyota would make in the US, for example. And they generate profits and interest in dividends and the reinvested earnings. So that, in theory, should flow back into Japan. But the problem is, despite, so if you look at textbooks, a record current account is usually driven by a trade surplus, but in Japan's case, we have a trade deficit. And the current account surplus is actually being driven by what's called the primary income balance, or just primary income, which is what I just said. It's a net flows in interest dividends and the invest in earnings. Right. So what's happened to being a bit slow on this? So it's Japanese money being invested overseas. Yeah, Japanese money. That's a bit slow on some of these things. Right. But I mean, that's good for the economy then. I mean, it's almost as good as exports, isn't it? Well, yes or no? If the money comes back to Japan, yeah, that should support the end, right? Because it should be repatriated and converted back to the end. But what's happening now is that because the current account looks weird, in most countries, if you have a current account surplus, it's driven by a trade surplus and the primary income is small. But in Japan's case, we have a trade deficit and the primary income is huge. And so what happened is that it's not generating natural demand for the end like it should. And what's being happening is that when Japanese investors and Japanese companies, they invest in factories abroad or they invest in US treasuries or Apple stock or whatever, that's being reinvested in that market. It's not being converted into the end. So it's not creating the textbook form of natural demand for the end like it should, or like a US. So this is Japanese. The reason this has been happening, I wonder whether it's reversible though, is Japanese companies, particularly, I guess we're talking largely car manufacturers, aren't we, for a chunk of this? That's a big portion, yeah. Saying, well, okay, the money's being made overseas, we can run the factories overseas, we haven't got the people here, the domestic market is looking pretty sick. And so all these companies, Japanese on paper, are operating largely overseas now. It started with a trade war, but yeah, okay. Okay. Okay. Well, it makes a great deal of sense. Okay. So we can avoid tariffs, et cetera. But the domestic market's starting to pick up now. So are you going to seem, is that going to become a bit more back into balance? That is the big question. So FX markets are extremely hard to forecast, right? And they can turn on a dime if Trump says something, it moves, right? If Powell says something, it moves. If you get a weak CPI printed moves. So companies and investors are naturally cautious. So in response to the trade war of the late '80s, and I guess the '90s, Japan had to relocate a lot of factories to the U.S. and they're producing cars over there or in Mexico. But if the end's so weak now, in theory, they should bring those factories back and export from here, but that's a hard decision. But it's what China's doing, of course. I mean, China is starting to expand a little bit overseas, but by and large, in terms of electric vehicle manufacturers, for example, I mean, China is leading the way within China and exporting. Good point. Yeah. So why is Japan not able to do the same? That's actually one reason why they treat the currency as like a sovereign territory. They don't want the U.S. treasury to label them a currency manipulated. They are very protective of their currency, because they've seen what happened to Japan after the Plaza Court. But no, like I said, I think it's a very difficult decision, and it's one that senior managers around Japan are trying to make. Is this weakness transitory, or is it semi-permanent, or someone can be treating it? Right. But you think that there will be more investment happening within businesses that are going to be based in manufacturing in Japan. But doing what? Making cars? Because the other thing, of course, is a lot of investment now has gone on the digital front. It's not electronics and manufacturing. It's obviously the Magnificent Seven, and Japan is just not there. Not the Magnificent Seven, but Japan is very good with the hardware. They're not so good with the software, but they're very, very good with the hardware. Very reliable, very high quality. You've probably seen that TSMC has made large investments here. There's a pretty long list of other tech companies around the world that have made FDI here in Japan. All this is thanks to the supply chain shocks during Corona and the semiconductor crisis. Cars overseas companies are seen in Japan as the alternative factory to China now, which is great. Yeah, for sure. Absolutely. On the tech side. Yeah. Of course. And in common, manufacturing as well, of course. So on that, that must mean that the difference between the exchange rate between the US dollar and the Chinese one, and the US dollar, and the yen, is vitally important. Because obviously it's who can provide the best quality product at the best price, always, and exchange rates are going to be very important in that. Yes. So if your local currency is cheap, that means your exports are cheap, and that means your export competitiveness is high. So exporting countries like Japan, China, and other Asian countries, they, in general, may prefer a weak currency, but like I said, a lot depends on the relationship with the US. If the US doesn't like it, they'll hit you with something like the popular court, or a president could say something, or said chair can say something, and or the treasury secretary can say something and destroy the weak currency. So, and right now, because the US-Japan relations are very, very good, some are saying that it's the best, the best ever, that's supportive of a weekend. So, if you are getting all of this foreign investment happening, because the opportunity looks so great right now, and that's the pitch you're painting, are there the people to meet this demand? We talked about the, you know, the aging population, I mean, it's not going to be an issue. It's a huge issue, yeah, labor shortage is a huge issue across many industries. AI, artificial intelligence has helped, is hope to be, help offset the labor shortage in a lot of industries, and it is. It's great for translate. The main difference between this version of AI and past versions, is that, for example, Tata GPT, and like, was it co-pilot, it works in Japanese. Oh, well that helps. Past versions of AI, you had to be, you had to use it in English, which made it very hard, but now that they work in Japanese, it's huge. And Japan made its name, obviously, through, you know, through automation. You know, this isn't, this isn't, this stuff isn't new to you. You know how to make stuff with, with the minimum number of people involved. But it was, for example, robots are very big in Japan, and we had some leading robot manufacturers. But the software is something new, and that should support GDP in Japan as well. But going back to the end, sorry, there's some other reason that I really should talk about as to its structural weakness. I wrote a piece called, "Is the Yans Weakness More Structural Now?" And it's free, it's on the JPX, Japan Exchange Group website, and Mackebon. But there's, besides that reinvestment theory, which is being driven by a former colleague of Miami's, who dies to Caracama, besides his reinvestment theory of the current account that I talked about, there's three other reasons that I should mention. One is the interest rate differential. A wide interest rate differential with the US is, is always an obvious driver over a week or a year, but what's different this time is that it could remain wide because US inflation is so sticky. And so if the, if the interest rate differential remains wide, that would, that would cause the Yans to stay weak as well. Right, because, because the Fed obviously, well, they might end up, I mean, the expectation is that the, the neutral rate will be higher, but then also, you know, the interest rates are going up in Japan. So, I mean, aren't they going to meet in the middle, perhaps? I mean, why, why would we see that necessarily equating with a, a week a yen? But it won't go back to like a zero percent differential. So Japan, the US had like near zero rates for a while, and Japan had near zero rates for them very long while. And so the interest rate differential was about zero. Those days are behind us, right? Okay. That's right. Thank you. Yeah. Okay. Yeah. Okay. The other factor's driving the end. Yeah. I got two more. One is what's called a NISTA expansion. It stands for the NIP-1 individual savings account. It was modeled off the US ISA, I'm sorry, the UK's ISA accounts. So that's a tax-free investment vehicle, sorry investment account. And that was greatly expanded in January this year. And what that did, was that increased flows to US stocks because everybody loves US stocks. So, and the S&P 500 is almost treated like a government bond these days. So you can always tax-free money going overseas basically. Yes, and that's driving demand for dollars, which makes the yen weaker. And also what's interesting is that there's two forms, there's two accounts to the NISTA accounts. There's a growth account and what's called an installment account. And the installment accounts are basically automated because you would like set it up to buy $1,000 worth of US stocks every 20th of the month. And so every 20th of the month, regardless of where markets are trading and regardless of where the dollar yen is, it's going to buy dollars. And so that the NISTA expansion, that would mean more periodic, automated, selling on the yen. And that should also help the yen to stay weak as well. So that was-- So the government will be regretting making that decision, won't they, won't they, because I mean they certainly have in the UK where, and I wish you soon, I said, "Well, okay, we're going to extend the ISA arrangement so that you can get extra and extra allowance as long as you invest in domestic companies in the domestic share market, for example." So I mean, Japan could have done that, couldn't they, because I said, "Well, this tax-free investments have to happen in Japan." Great question. One treat that they should have made was to make a domestic bucket. And so they didn't really give you enough incentive to buy domestic stocks, so I think that might be coming. So that happens. You're getting more foreign money coming in as well, you're getting more investors coming in because the opportunity is just so great. You still got the issue of obviously about the workforce. I mean, that's going to be actually out of all of it. That's the inhibitor to growth, isn't it? So you've got to get more people back in the workforce. How are they going to do that? That's hard, but especially on the services side, like restaurants and hotels, even if they hike wages, it's really hard for them to find staff. No, that is a very hard question. I don't have a good answer for that, but everybody's working on that. And so companies are generating profits overseas, take advantage of the newly competitive yen, for example. So the upshot out of all of this, we spend a lot of time, particularly on this podcast, talking about whether the Bank of Japan is going to lift interest rates and whether they're not. And I've been asking the question at 10 basis points, does it really make that much difference? So I mean, will they? I mean, it is just a delicate balancing act from that point of view, isn't it? It could. No. Well, so they've been waiting and waiting and waiting and waiting and waiting to hike, and they did their first hike in what, 17 years in March? So that was their first hike in 17 years, and they might do one more this year and maybe a couple next year and take the policy rate to one. It's like 0.1 now, but it could go to like one or 1.5. Do you think it'll get that high? Yeah, over the next year or two, yeah, maybe. So it is a sea change for Japan, having interest rates that high. I know 1% or 1.5% is low by your standards before us. And the consequences for that, well, it's happening because all of a sudden, you've got inflation. The one thing that you've been hanging out for for decades, you've got, which as you say, is turning the key on the car and the economy is starting to shoot up again. So that creates a big investment opportunity. That's the takeout message. Yeah. Japan is, there's an inflation revolution going on, and I think it's best if you come over and see it. You just got enough tourists as it is. What is an interesting conversation as well about, you know, is that another investment opportunity, the Japanese tourist industry, because everyone wants to go there. I know so many of my family and friends who've been there who didn't used to go because it's so expensive. All of a sudden, it's a great opportunity, isn't it? No, it's very cheap. Yeah. Harry, it's been great talking. We'll have to get you on again sometime soon. We could have talked for a lot longer, but thanks for giving us the low down on where Japan is right now. It sounds like a fantastic opportunity there. Thanks very much. Thank you. Now, next week, we're back to talking energy, Leonard Kwong from Bloomberg NEF will be joining me. He's the head of Australian Research. That's next weekend. And I'm back on Monday morning for the week, edition of the morning call in a week where, amongst other things, we will be talking about the Bank of Japan because they're meeting on Tuesday. I'll catch you on Monday. Enjoy the rest of your weekend. I'm Phil Dobby for NAB. Thanks for listening. The Weeknd Edition. Candidation. [MUSIC PLAYING]