“Let your plans be dark and impenetrable as night, and when you move, fall like a thunderbolt.”
― Sun Tzu, “The Art of War”
On October 31, at the end of its monetary policy meeting, the Bank of Japan (BOJ) surprised markets by announcing additional monetary easing. This was the first significant increase in the BOJ’s Qualitative and Quantitative Easing (QQE) program since its launch in April 2013.
The BOJ seemed to take a leaf out of Sun Tzu’s “The Art of War” with the swift timing and formidable scope of its new monetary expansion. At PIMCO, we have long maintained that Japan needs to pursue an “audacious” monetary policy in order to finally defeat the deflationary mindset that has plagued Japan’s economy for almost two decades (see the March 2013 Global Perspectives, “Whatever It Takes in Japan? It Takes an ‘Audacious’ Monetary Policy”). We believe October’s announcement is a very positive development and an important next step in Japan’s fight against deflation.
Under the increased QQE program, the BOJ will expand its monetary base at an annual rate of ¥80 trillion. At this pace, its balance sheet as a percentage of GDP, a figure which has already eclipsed those of other major global central banks, will reach 75% by the end of 2015 (see Figure 1). The BOJ will increase purchases of Japanese Government Bonds (JGBs) by ¥30 trillion to ¥80 trillion per annum, and the average maturity of JGBs purchased will increase from the current range of about seven years up to seven to 10 years (see Figure 2). The BOJ will also triple its annual purchases of equity exchange-traded funds (ETFs) and Japanese real estate investment trusts (J-REITs) to ¥3 trillion and ¥90 billion, respectively.
Critically, the BOJ made its newly expanded QQE program open-ended “until the 2% inflation target is reached.” In terms of scale and impact, this expansion of QQE is as significant as the original announcement of QQE.
By going ahead with such bold expansion, despite a 5–4 committee vote, BOJ Governor Haruhiko Kuroda reasserted his strong and clear commitment to do “whatever it takes” to achieve the 2% inflation target. In light of weakness in demand following the April VAT hike and the recent drop in oil prices, Governor Kuroda recognized that if the current downward pressure on prices remained, there was a risk that “conversion of the deflationary mindset,” which has been progressing steadily so far, might be delayed. To manage this risk and maintain the improving momentum of inflation expectations, the Bank judged it appropriate to expand the QQE. We couldn’t agree more.
On the same day the BOJ announced its policy decision, the Government Pension Investment Fund of Japan (GPIF), Asia’s largest public pension fund with ¥127 trillion in assets, detailed much-awaited plans to change its asset allocation (see Figure 3). Their new model portfolio will have a much smaller than expected share of domestic bonds (35%) and a much larger than expected share of foreign equities (25%). Increases in allocations to domestic equities (25%) and foreign bonds (15%) were similar to recent expectations, though these increases, too, are still significant in size. Following the GPIF’s announcement, it is very likely that other public pension funds and private sector investors will also increase allocations to domestic and foreign risk assets in their portfolios.
Potential impact on markets in Japan and around the world
Combined, these BOJ and GPIF actions underscore our ongoing investment thesis in Japan, one of policy-led and coordinated asset reflation. And given today’s closely connected financial markets, the flows brought about by these actions in Japan could have a major and lasting impact on asset valuations across the global investment landscape.
Starting at home, the BOJ’s QQE will drive the yields on longer-maturity JGBs significantly lower. While the BOJ’s purchases in the five- to 10-year sector remain the same, it increased by 250% its target purchases in the 10- to 40-year sector. This will decrease the net supply of long-end JGBs available to the rest of the market by as much as 75%. Although the GPIF will be reducing its JGB holdings due to changes in its asset allocation and the Ministry of Finance may increase its JGB issuance in the long end, the BOJ will be able to absorb this increased supply to the market easily. Given the massive size of the BOJ’s purchase operations, we believe the long end of JGB curve will continue to outperform in the near term.
JGB yields are only likely to turn higher after the BOJ signals it is ready to end or taper its QQE operations, similar to what we saw in the U.S. Treasury market in the summer of 2013. One possible motivation for this move would be clear signs that inflation has met the BOJ’s target. We believe it is unlikely to happen over our cyclical horizon.
Turning to equity markets, the combination of GPIF’s asset reallocation and the BOJ’s QQE is a powerful policy-led portfolio rebalancing through public balance sheets, and we expect it will act as a positive catalyst. To put this asset allocation shift in perspective, potential purchases of domestic equities – even just by the GPIF and other public pension funds that are mandated to follow GPIF – are likely to be larger than all net purchases of domestic equities by investors outside of Japan since the beginning of “Abenomics” in 2013.
The currency markets will also feel the effects. The yen has been on a consistent weakening trend since the beginning of Abenomics. In fact, yen weakness has been a key transmission mechanism in Japan’s efforts to reflate the economy. By coincidence, the week when the BOJ expanded its QE operations was also the week when the Federal Reserve finished tapering its QE program, and since then the yen has weakened by a further 5% against the U.S. dollar. We believe that the yen weakening trend is set to continue: Following the end of the Fed’s QE program, monetary expansion in Japan will be even faster relative to the U.S.
The impact of the BOJ/GPIF actions will spill over into global asset markets. Beginning with currencies, sharp devaluation in the yen is likely to raise red flags in other countries, particularly those who are either competing with Japan in global export markets or trying to weaken their own currency to stave off their own deflationary forces. This is nowhere truer than in Europe: The ECB has been engaged in efforts to weaken the euro ever since it ran out of conventional policy room and cut its key policy rates below zero (even lower than Japan). Other central banks have also voiced frustrations with relative strength in their currencies in recent months – Korea, New Zealand and Australia, to name a few.
In our view, this expansion of QQE will also have a large impact via the portfolio rebalancing channel. Over the years, the JGB market has become increasingly segmented, with banks primarily invested in the front end while real money investors like pension funds and insurance companies dominate holdings in the long end. As the BOJ starts buying many more long-end JGBs, the displaced real money investors are much more likely to buy equities and other risk assets to replace income lost from their JGB holdings that were sold to the BOJ. Real money investors usually operate with higher return targets than banks and therefore tend to have a larger risk appetite.
Portfolio substitution effects from the BOJ/GPIF combined action will therefore lead to increased flows of funds from Japan into global bond and equity markets as Japanese investors reach for income and returns. When we analyze past trends in flows of funds from Japan and look through the lens of current valuations, we believe that the largest recipients of such flows are likely to be U.S. Treasuries, global investment grade credit, European semi-core government bonds (such as France) and, to a limited extent, European peripheral government bonds.
Riskier asset classes like equities and emerging market bonds are also likely to see inflows from Japan; however, we believe these flows will be much smaller in the context of overall market size and likely will not have a significant relative impact on valuations.
A bold step, but more action is needed
Japan has taken a coordinated, audacious step to fight the risk of deflation. Bold, committed QQE and engagement of the public sector balance sheet is a very welcome and very necessary, but not sufficient, condition to achieving economic growth and fiscal sustainability. In order to succeed, Abenomics needs to deliver on its second and third arrows of fiscal and structural reform policies in a credible way.
Whether or not investors believe in the eventual success of Japan’s policies, they need to anticipate the implications of such powerful forces affecting local and global markets, and position their portfolios appropriately, according to their objectives, to preserve capital and generate excess returns.