Morningstar's "Perspectives" series features investment insights from selected third-party contributors. Here Viktor Nossek, director of Research at WisdomTree Europe discusses how corporate releveraging and QE in Japan mean great things for the stock market but not the yen.
Attempts by corporate Japan to re-leverage in 2006 had been cut short by the seizing up of the banking system in the 2008 credit crisis and by the tsunami disaster in 2011, when much of Japan’s infrastructure was destroyed. It has only been in recent years that the gradual economic recovery and improving business sentiment has encouraged Japanese companies to take on more debt.
As shown in the chart, since 2012, corporate re-leveraging has accelerated, with borrowing from banks by small and mid-sized companies outweighing the redemptions of corporate bonds by large companies. The aggregate effect has been that while corporate Japan paid down some $68 billion of corporate bonds since 2012, almost four times as much has been taken out as bank loans in the same period.
April’s Bank of Japan’s Senior Loan Officer Survey also shows that increases in loan demand have been attributed to not just rising working capital requirements or falling interest rates, but increasingly to rising investment needs as well.
Corporate Re-Leveraging Unlocks Shareholder Value
If companies’ longer term investment decisions become a bigger driver for corporate borrowing, then inflation expectations in Japan are likely to become more firmly entrenched. Its positive spill-over effect is the incentive for companies to put their excessive cash reserves to work, thereby unlocking shareholder value in the process. Significant cash hoarding of corporate Japan in recent years is evident in Bank of Japan’s Flow of Funds report. For instance, since 2012 corporate Japan accumulated an additional 30 trillion yen ($240 billion) in cash on top of existing cash and deposit balances of 223 trillion yen ($2.7 trillion as at end of December 2011), which was more than the 28 trillion yen ($225 billion) of companies’ combined foreign direct and indirect investment flows over the same period.
In a deflationary environment, it made business sense to hoard cash to such a degree. But the prospect of domestic demand-led growth anchoring in inflation is likely to spur management to beef up their dividend policy, offering better cash returns to shareholders in the future. The potential for this to increase shareholder value should not be underestimated, given how detrimental cash hoarding has been to shareholder returns. For instance, gauged by MSCI equity indices, Japanese large-cap stocks have ROE of only 8%, much lower than the double digit ROEs of most of Europe’s and US equity markets.
At around 2% of GDP, the re-leveraging of corporate Japan has reached levels that are close to the degree with which it accumulates cash. Hence, corporate re-leveraging has potential to rise by more as it has not deteriorated the credit and liquidity metrics in any way. In fact, prime lending rates of banks hover around 1.1%, which is not only historically very low in nominal terms, but in real terms is well below the rate of inflation (of which the annual growth rate has been positive and rising steadily since the summer of 2013). Hence, the macro conditions now are likely to provide the strongest incentive yet for companies to add more leverage to their balance sheets and optimise the capital structure, along securing cheap longer-term financing for expansion and investment programs.
Entrenched Inflation Beyond Unwinding of QE Keeps a Lid on the Yen
After corporate borrowers have been largely absent when Japan first introduced its zero interest rate policy and embarked on its first broad-based QE program absent since the beginning of the decade, corporate re-leveraging is giving Abenomics’ QE plan a major support driver that appears to have triggered a lasting rebound in inflation.
As shown in chart 2, both the actual and implied inflation readings have been effectively hovering around 2% since 2014, this at a time when two large macro trends may have had an offsetting effect to consumer prices overall: the fall in crude prices oil and the depreciation of the yen. Hence, if the rise in inflation in recent years has increasingly been led by improving domestic demand in Japan and was less affected by the volatility in commodity markets and trade, it should give inflation fundamentally a much stronger footing to sustain itself.
The irony may be that with Japanese inflation expectations sustained at 2% and close to US inflation, a consequential unwinding of QE by the Bank of Japan may not help the yen rise in value. In fact, given that the real interest rate differential between the US and Japan is likely to rise as a result of inflation forcing Japan’s real interest rate lower while a tightening cycle by the Fed forcing it higher, the fundamentals for the yen relative to the dollar should remain weak. The pressure on the yen to devalue may continue to persist for longer well after Japan exists QE.
Foreign Investors bullish on Japan may want to consider the risk of yen devaluation in that regard, which can have a detrimental effect on the equity return of Japanese equities when converted into their home currency.
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