Japan's Recovery: Beyond the Stock Market
The recent surge of the Dow Jones Industrial Average above 40,000 points represents a significant milestone after 128 years of trading history. This remarkable achievement comes on the heels of weaker-than-expected inflation data from the United States, coupled with better-than-anticipated corporate earnings. Retail investors have rushed into the market, significantly impacting trading volumes, especially during considerable options settlement days. This has resulted in one of the longest streaks of gains in the U.S. stock market since February. While the bond market and interest rate futures displayed reactions to the latest economic data, the aspirations for interest rate cuts did not persist for long. Last Tuesday, Federal Reserve Chair Jerome Powell encapsulated the market’s sentiments regarding rate prospects, emphasizing patience and the need for restrictive policies to work as intended.
The frenzy in the stock market has been mirrored by an even more intense enthusiasm in commodity markets. The uncertainty surrounding supply chains has fueled significant price increases for metals such as copper and nickel, contributing to a widespread rise in nearly all commodity prices. Oil and precious metals, including gold and silver, have also performed admirably, while the U.S. dollar showed signs of retreat.
After three consecutive months of inflation surpassing expectations, the U.S. economy has finally experienced a moment of relief. In April, the Consumer Price Index (CPI) increased by 3.4% year-over-year, slightly down from the previous 3.5%; on a month-over-month basis, it rose by only 0.3%, below the earlier 0.4%. Core CPI, which excludes food and energy costs, showed a year-over-year increase of 3.6%, representing the lowest increment since the pandemic began and a monthly rise of just 0.4%, making it the first month in six to show a deceleration in inflation growth.
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Economically speaking, this data could be seen as a refreshing downpour for an economy that has long been plagued by overheating issues. Finally, there is a data point that isn’t exceedingly robust, and discussions among economists about interest rate cuts starting in September are resurfacing. Yet, the market response has been tepid. The two-year Treasury yield, the most sensitive to policy interest rates, fell by a mere three basis points over the week, indicating that funds do not view this inflation data as having a significant impact on monetary policy.
There are two critical reasons for this lukewarm market reaction. First, a single month of data is insufficient to establish a new trend, let alone to shift the cautious attitudes of policymakers. The benchmark response is akin to a collective acknowledgment of "noted." Secondly, during this phase of declining prices, commodity prices have fallen significantly more than services, while the Fed is more focused on the trajectory of service prices, particularly concerning wage growth and the spiral of increasing service costs, rather than on the drop in auto prices.
Service pricing, however, warrants close attention. Aside from noise factors like falling airfare and rising automotive insurance, the most notable issue is the gradual decrease in rental prices, albeit slowly. Rental agreements are influenced by cyclical contracts, making them relatively stable, but once seasonal adjustments are removed, the pressure from rents on core CPI is turning. The largest component of the CPI, rent, is expected to enter a phase of controlled escalation. While this may not directly alter the trajectory of interest rates next month, it does add certainty to potential rate cuts next year.
Traditionally, Wall Street wisdom maintains a correlation where a decline in the bond market inversely corresponds to a rise in the stock market. This dynamic results from capital rotation among asset classes. Simply put, when interest rates hover around zero, the nominal yields on fixed-income products become extremely low, minimizing the opportunity cost of capital. As a consequence, funds gravitate towards riskier assets, leading to higher prices and valuations for equities. Conversely, when rates are elevated, the stock market typically feels the pressure. The Fed’s discourse around keeping rates higher for longer has indeed impacted the stock market, leading some investors to consider Treasury securities that can now yield around 5% without any risk.
Nevertheless, a recent unsettling trend is the apparent disruption in the negative correlation between stocks and bonds. Despite Treasury yields remaining elevated, the stock market has shown resilience, continuing to hit new highs. This robustness isn’t limited to equities; commodities, gold, and even cryptocurrencies are experiencing significant gains. What accounts for this phenomenon? It appears that a total disregard for risk propels funds towards risk assets, thereby amplifying leverage and risk weight. The CBOE Volatility Index (VIX) has plunged below the 12 mark, one of the third-lowest levels since data collection began in the early 1990s, reflecting a persistent low volatility environment. There’s a notable trend of funds moving from American savings into capital markets, with over $10 billion entering U.S. stock markets weekly.
This commentary has previously explored Japanese monetary policy and exchange rates; let’s pivot to the recovery of Japan’s economy. Japan has tentatively achieved its target of 2% inflation, buoyed by negative interest rate policies from the central bank, while the Prime Minister has declared the end of an era of deflation. The economy is steadily exiting recession, with export firms posting record profits, wage growth accelerating, improved consumer spending, and a surge in tourism, contributing to a vibrant stock market. Indeed, the current condition of Japan’s economy contrasts sharply with trends seen over the past three decades.
However, Japan’s economic resurgence exhibits uneven characteristics, predominantly driven by external factors. The drastic depreciation of the yen has significantly altered trading conditions and corporate profitability. Imported goods have become more expensive, generating inflationary pressures linked to energy and food prices, compelling households to shift savings into the consumption market. Conversely, export goods have become cheaper, driving sales in foreign markets and substantially improving corporate earnings when measured in yen. Additionally, the persistent yen depreciation has made foreign investments more attractive, sparking a tourism boom and inflow of overseas funds.
Nevertheless, the recovery in domestic consumption and local fixed asset investment remains sluggish. Despite rising wages and prices, actual disposable income for residents has not increased significantly, leading to subdued consumer sentiment. Limited internal consumption, along with an aging population structure, reduces domestic investment enthusiasm among enterprises, resulting in a persistent scarcity of stable employment opportunities.
Japan currently grapples with coexisting trends of externally driven inflation and domestically rooted deflationary mindsets. The former, propelled by a weaker currency, has superficially altered Japan’s economic landscape; however, the lingering deflationary sentiment continues to shape deeper aspects of economic confidence, investment intentions, and growth momentum. This deflationary mindset did not transpire overnight; it cannot be remedied instantly by mere currency depreciation. Japan’s potential to fully escape the losses from three decades of stagnation hinges not on the fluctuations of the stock market but rather on the consistent and autonomous improvement of consumer spending.
The yen's continual decline symbolizes a double-edged sword. While a weak yen has brought several advantages aforementioned, it also erodes the purchasing power of Japanese citizens, leading to overcrowding from foreign tourists, which can breed social tensions. An excessively weak currency inevitably skews resources towards external sectors, counteracting domestic stimulus intentions. The Japanese government has introduced an array of measures to address the yen’s devaluation, but the results have been less than satisfactory.
The fundamental logic behind the yen’s persistent depreciation lies in its interest rates, which remain markedly lower than those of the United States and other developed nations, giving rise to significant interest rate differentials. This differential has not only driven substantial outflows of Japanese savings but also catalyzed an influx of arbitrage activities that have placed prolonged downward pressure on the yen. The Japanese government has openly called for a halt to aggressive short-selling of the yen; yet, many argue that this predicament stems from monetary policies that are fundamentally misaligned with market realities.
In the upcoming week, all eyes will be on the Federal Reserve's meeting minutes from May 1. Given the increased inflationary pressures, the Federal Open Market Committee (FOMC) appears to have ruled out the possibility of interest rate cuts in June, although the post-meeting statements and press conference comments remained somewhat measured. Observers are keen to analyze the commentary regarding supply-side price pressures that may ease. Additionally, significant attention will be focused on the consumer price index (CPI) readings from both Japan and the United Kingdom.