It was one of the biggest stock market and asset price bubbles in modern history…
I’m talking about the Japan economic bubble that burst in 1992.
From 1986 to 1991, the country saw staggering valuation explosions, totally detached from reality, across equities and real estate assets.
From its peak in 1990, Japan’s stock market fell by more than 80 percent, hitting its low in 2009. Even today it’s still over 40 percent below its previous top.
By comparison, it took the S&P 500 less than seven years to surpass its global financial crisis highs. The index is now 65 percent above its previous pre-Global Financial Crisis peak.
Now, after several “lost decades”, Japan’s market is finally ready to catch up to the rest of the world.
The Japan economic bubble
Before we get to Japan’s comeback, let’s take a closer look at what happened.
Between 1982 and the end of 1989, Japan’s Nikkei index ripped more than 400 percent higher. Stocks in the rest of Asia were not doing anywhere near as well as those in Tokyo.
One of the best ways to illustrate the craziness of the Japanese equity market bubble at the time is in the following chart. It shows the total market capitalisations of the Japanese and U.S. equity markets over the 20-year period from 1977 to 1997.
Focus in particular on the grey shaded area, which shows the ratio of the total Japanese market cap to U.S. market cap.
In 1977, the Japanese equity market was roughly 2.5 percent of the entire U.S. market – that is, the U.S. stock market was 40 times larger. But by 1988, Japan’s stock market was 36 percent bigger than the U.S. market. On a relative basis, in a little over a decade, the Japanese equity market grew over 50-fold compared to the U.S. – and substantially surpassed it as the largest market in the world.
The Tokyo real estate market was also utterly absurd at the time.
As you can see in the chart below, the price of Tokyo retail, commercial and residential real estate tripled in the latter part of the 1980s.
Land prices were so high that the Imperial Palace grounds in central Tokyo, an area of 3.41 square kilometres – almost exactly the same size as New York’s Central Park – was worth more than all of the real estate in the state of California.
But it couldn’t last. Like every financial bubble, when everyone’s having such a good time, no one wants the party to end. But end it did…
On December 29, 1989, Japan’s Nikkei Index peaked at 38,915. This was up from around 7,000 at the end of 1982. And then the bubble burst, and the Nikkei fell 60 percent over the next 30 months.
The excess money supply and credit pouring into the system, rampant speculation and euphoria that were all part and parcel of the Japanese bubble economy were replaced with panic.
Since then, the Nikkei hasn’t come remotely close to hitting that peak level. The index now stands at around 22,000.
Meanwhile, the downturn in the Japanese real estate market, Tokyo in particular, was astonishing. By 1995, Tokyo commercial real estate prices had fallen 70 percent from their 1990-1991 peak. And by the early 2000s, prices would fall another 50 percent.
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The lost decade(s)
In the aftermath of the 1980’s bubble, the Japanese economy has experienced nearly three decades of stagnation, and a persistency in deflation unlike anything we’ve ever seen in a developed market.
Since 1990, the year-on-year Consumer Price Index (CPI), the most commonly used measure of annual price changes (i.e., inflation), has been negative for 161 of 330 months. That means nearly 50 percent of the time, on a monthly basis, the price of a standard basket of consumer goods has declined in price over the previous year.
This kind of chronic deflation is a deathblow to economic growth. When prices keep falling, consumers postpone their purchases because things will only get cheaper. This reduces economic activity. Central banks respond to deflationary pressures by lowering interest rates, making borrowing cheaper for businesses to expand and consumers to buy.
But interest rates can only be cut so far.
The Bank of Japan’s benchmark policy rate has been below 1 percent since 1995. And since early 2016, it has actually been negative. But even with zero interest rates, if there is deflation, then real (i.e., inflation adjusted) interest rates are still positive. (Real interest rates are calculated by subtracting the rate of inflation from interest rates. With rates at zero percent and deflation, it means you are subtracting a negative inflation number from zero – which gives you a positive real rate.)
That means there is still an incentive to simply hold cash at the bank. Most of our readers around the world are used to the idea of inflation decreasing the value of their cash. But in Japan, the opposite has happened for decades. In Japan, deflation has actually increased the value of cash held at the bank. If a basket of goods costs 100 yen this year, my 100 yen in the bank next year (even with zero interest) is worth more – because deflation implies that same basket of goods will be worth less than 100 yen next year.
“Abenomics” takes monetary easing to a whole new level
Japan’s economy was put on a new path in 2013 by newly re-elected Prime Minister Shinzo Abe, who launched what became known as “Abenomics”. Its “three arrows” of economic policy have guided economic policy ever since.
In principle, there is nothing radical about the policy of “three arrows”. The “arrows” include monetary easing (i.e., easy, cheap money policy as adopted by central banks everywhere since the global economic crisis), fiscal easing (i.e., government spending) and structural reforms to promote growth (i.e., deregulation and implementing pro-growth policies) – all widely used policies around the world.
The idea was, and remains, that flooding the banks with cash and inflating asset values spurs borrowing and investment.
But Abenomics ramped this up…
Since 2013, the BOJ’s historical balance sheet has exploded from US$2 trillion to over US$4.5 trillion. That’s about the same as the Federal Reserve, the American central bank – but the U.S. economy is nearly four times the size of Japan’s in terms of GDP.
This policy program has gone through fits and starts, but the Japanese economy appears to be on the verge of finally entering a period of sustained growth.
It’s time for Japan to play catch-up
The Japanese economy is doing better than it has for years. Its GDP has grown for six consecutive quarters, which is the longest period of sequential growth since the mid-2000s. Household spending also showed annualised growth of 3.7 percent in the last quarter. And capital expenditure in the economy (the amount companies are investing in their businesses) saw annualised 9.9 percent year-on-year growth in the last quarter.
Meanwhile, Japan’s manufacturing confidence hit its highest level in a decade. Sentiment among Japan’s large manufacturers is at its highest level since September 2007, according to the quarterly Tankan survey by the Bank of Japan.
(Japan still faces a big demographic crisis, as we’ve written before. But markets move in cycles of months and years – not decades. So there’s plenty of scope for a strong rally in Japan’s stock market despite looming problems down the road.)
In the year to date, the MSCI Japan Index is up 16 percent, compared to about 14 percent for the MSCI World index.
I think Japan has a long way to go. So if you’ve been ignoring Japan (like most investors) these past few years… now might be the time to take another look.