Will central banks take different paths in road to recovery?

Will this week’s key announcements from the Bank of Japan and the US Federal Reserve show the start of greater divergence in central bank policy? Jason Hollands, managing director at Bestinvest, gives us his view.

Will central banks take different paths in road to recovery?

The actions and guidance provided by central banks have been the primary movers of investment markets in recent years as these institutions have been the suppliers of vast amounts of liquidity into the financial system in the aftermath of the global financial crisis. In fact Deutsche Bank has estimated that central banks around the globe have cut interest rates an astonishing 672 times since the collapse of Lehman Brothers eight years ago.

Yet after years of all major central banks pushing down the accelerator in the form of ultra-low interest rates and expanding the supply of money in circulation, the road ahead is likely to see greater divergence in policy. The Fed is itching to raise US interest rates again, having raised interest rates last December for the first time since 2006, while closer to home the Bank of England seems set on keeping policy loose with the potential for a further rate cut this year.

Bank of Japan: equivalent of Pac-Man

The Bank of Japan statement this morning has been keenly awaited by market watchers as it has been the most aggressive of all central banks in its actions to try and stimulate economic activity. Under the tenure of Governor Haruhiko Kuroda – an ally of Prime Minister Shinzo Abe – the BoJ has long had in place a vast Quantitative Easing asset purchase programme which has seen the creation of new money to be used to purchase financial assets with the aim of reducing yields and therefore borrowing costs and getting more money into circulation.

In massively expanding its balance sheet through such actions the BoJ has acted like a financial version of the cult arcade game character Pac-man as it has gobbled up more than a third of the entire Japanese government bond market, stoking debate over whether it would eventually run out of bonds to buy. In addition, earlier this year the BoJ stunned the markets by shifting interest rates into negative territory with the aim of encouraging banks to lend more, a move which ended up hurting bank profitability.

Yet despite this array of shock and awe policies which had some initial success in aggressively driving down the value of the Yen – and in so doing improving Japanese competitiveness – Japanese economic growth is weak, inflation is way below the BoJ’s 2% target and, worse still, the Yen has strengthened significantly again over the past year.

New policy framework

This morning the BoJ announced a new policy framework having committed to undertake a full review of its approach. This amounts to a shift in focus rather than “new” stimulus and in effect confirms a growing view in the markets that it has reached the limits of what it can do.

It has kept its key policy rate on hold at 0.1% as expected but the new development is in its approach to Quantitative Easing where it is to adopt “yield curve control” as the centre piece of its strategy rather than expansion of the monetary base per se. This means its goal now will be to keep 10-year Japanese government bond yields “at around their current level” i.e. focusing action specifically on keeping longer term borrowing costs stable and having greater flexibility in its methods.

It has in turn ditched rigid targets around the expansion of money supply and the average maturity of the Japanese government bonds it holds. The sledgehammer approach has in effect been replaced with a scalpel.

The initial market reaction has been positive, with a weakening of the Yen and a rise in share prices, but only time will tell as to whether this approach is effective in achieving the desired increase in inflation. Some of the immediate market reaction will be simple relief in banking shares that the BoJ did not choose to push interest rates deeper into negative territory as some feared.

For long term investors the case for investing in Japan should not hinge on expectations of bold new monetary policy actions riding to the rescue as it is clear the BoJ is now at the limits of what it can do. Nevertheless, from an equity market perspective, the policy environment remains very supportive with highly accommodative monetary policy also being dovetailed with greater emphasis on fiscal stimulus through measures such as infrastructure spending which have previously been announced by the government.

Japanese equities

While the Japanese economy faces structural headwinds from its ageing population – which the UN estimates could decline by a third by the end of the century based on current trajectory – there are undoubtedly pockets of investment opportunities to be found in the Japanese equity markets.

Japanese equities are very under-researched by investment banks, especially further down the market cap spectrum, and this therefore provides good opportunities for active managers. Interesting areas include healthcare companies that can address the needs of an ageing population, technology businesses that can help find efficiencies to adapt to a shrinking work force and potential beneficiaries from increased infrastructure investment.

Another area of opportunity are real-estate companies with exposure to hotels which can capitalise on explosive growth in tourism. Nearly 20 million foreigners visited Japan in 2015, a staggering 47% increase on the previous year which soaked up room capacity in Tokyo. Numbers are expected to rise to 40 million by the time Tokyo hosts the Olympics in 2020 and so significant development is taking place. But it also important to note that the Japanese market is also home to many world class companies that operate globally and are less sensitive to the country’s domestic economic challenges.

Historically Japanese companies have hoarded cash and indeed remain cash rich. In fact around 55% of companies in the Topix Index are net cash positive which compares to just 19% of companies in the US S&P 500 Index. While the proportion of profits paid out to shareholders by Japanese companies is low by international standards the headroom to grow payouts is considerable.

Improved corporate governance has also seen a notable shift towards increased dividend distributions as well as share buybacks, so at a time of slow or declining dividend growth across other developed markets, Japanese companies offer potential income growth.

Investments worth considering for growth investors include Legg Mason IF Japan Equity which focuses on “New Japan” sectors that include technology and healthcare companies. And for those wanting a more conservative approach, the CF Morant Wright Nippon Yield fund and CC Japan Income & Growth Trust plc, a small investment trust managed by boutique Coupland Cardiff, both target companies with dividend growth potential from across the market cap spectrum.

Is November the danger month for the US?

Turning to the Fed meeting, the markets are expecting no change to US interest rates as the last official to speak ahead of the meeting was very dovish. But the signals in recent months have been mixed and a surprise rate hike today would certainly take the markets by surprise and likely trigger considerable volatility.

If rates are kept on hold, investors will be pouring over the guidance as to when the Fed will raise rates.  Many expect this to happen in November which is, of course, also the month when the US Presidential election, the most acrimonious in recent history, concludes.

The combination of higher US interest rates with the potential for a shock Trump victory could create an unsettling period for the markets. Most financial institutions appear to be currently factoring in the assumption of a Clinton victory despite the closeness of the polls and so a Trump victory could echo the shock response we saw to the UK’s decision to leave the EU. But the reaction could be more far reaching with emerging markets potentially bearing the brunt of any reaction.

Mr Trump’s advocacy of high tariffs on imports from China and Mexico would, if implemented, have a major impact on trade. Daiwa Capital estimates that Mr Trump’s proposed 45% tariff on Chinese imports (from a current level of just over 4%) could knock $420bn off Chinese exports.

Of course it isn’t a given that a President Trump would be able to implement his most controversial polices as a Congress controlled by establishment Republicans may be able to clip his wings, but the immediate reaction could still be quite brutal.

Emerging Markets will also be very sensitive to interest rate rises in the US as these would likely see a strengthening in the dollar. This would push up the costs of servicing the vast amount of dollar-denominated debt issued by emerging market companies in recent years, as well as triggering capital outflows back into US Treasuries as yields rise. Investors who have bought into the emerging market recovery story this year could find themselves wrong footed.

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