Of Interest

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Saturday, July 30, 2011

Japanizing of the Global Economy

Heavily indebted economies of Europe won’t collapse. They will enter a prolonged stagnation like Japan did in the 1990s, dragging the rest of Europe along. The US economy won’t collapse either. It will also slide into Japanese-style stagnation, dragging along emerging economies that have been thriving on its large and robust consumer market to sell their products—I call it the Japanization of the global economy.







The parallels between what happened in Japan in the 1980s and the 1990s and what happened in the US in the 2000s and the early 2010s are too similar to ignore: The blow and burst of residential and commercial real estate bubbles followed by massive monetary and fiscal stimulus that kept Japanese and US economies off the cliff, but failed to sir them back to their long-term growth path; leaving governments in both countries in heavy debt loads.

While not ignored, these parallels have been, unfairly, disregarded by mainstream economists and analysts alike, arguing that the US and Japanese economies are different in several respects. One difference is the role and the importance of the Federal Reserve vis-à-vis Bank of Japan. The Federal Reserve has a tradition of independence from the government, and therefore, can act faster rather than later when there is a clear and present danger for the economy. Yet the Bank of Japan began to act about six months after land prices began to slide, while the Federal Reserve was debating whether there was a real estate bubble six months after it burst.


Another difference is that American markets and most notably the banking system are more flexible and more responsive to crises than Japanese markets. This premise, however, doesn’t provide a magical solution to market imbalances that can be eliminated only through price adjustments. What it does provide is a fast rather than a slow and torturous adjustment. A third difference is in level of savings. Japanese households were savings nearly 20 percent of their disposable income when the housing collapse began in 1991. By contrast, the American saving rate is currently in the low single digits causing US consumers to borrow heavily to maintain their level of spending; and Visa’s record second quarter profit results confirm it.

Irrespective of which side one takes on this debate one takes, recent evidence on the US economy, including weak May and June employment reports, and today’s weak GDP report confirm that the US economy is heading for a prolonged stagnation-at a time that both monetary and fiscal policy are max-out. But what it means for investors?

Real Estate: Land in Japan is worth less than half its 1991 peak, while property in the United States has more than tripled in value, to about $17 trillion.
Homeowners were among the biggest victims of the Japanese real estate bubble. In Japan's six largest cities, residential prices dropped 74 percent from 1991. By most estimates, millions of homebuyers took substantial losses on the largest purchase of their lives.
Their experiences contain many warnings. One is to shun the sort of temptations that appear in red-hot real estate markets, particularly the use of risky or exotic loans to borrow beyond one's means. Another is to avoid property that may be hard to unload when the market cools.

Equities. While a slow-growth-low interest rate environment is usually good for stocks, stagnation isn’t. The Japanese stock market, for instance, is significantly below the levels it was at when the Bank of Japan launched its several rounds of QE, while the Japanese government built roads and bridges to everywhere and to nowhere.

Commodities. Whether industrial or consumer, including gold and silver, cannot defy a weak economy. Gold, for instance, declined throughout the 1990s, before take off in the early 2000s, catching up the US real estate bubble.

US Treasuries. A stagnant economy is usually associated with steady or even declining inflation, and that is certainly good for fixed income securities. The problem, however, is that fixed income prices are negatively affected by sovereign risk associated with soaring government debt. As evidenced by the performance of the Japanese government fixed income securities, as well as, by the behavior of the US Treasury market after the release of the first quarter weak GDP numbers, a weak economy supersedes sovereign debt risks for mature economies—a bullish case for bonds.

The bottom line: The US and the world economies cannot avoid Japanization, a bearish trend for Real Estate,stocks and commodities, but are bullish for US Treasuries.

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