2 May 2019

The sharp decline in equity markets during Q4 2018, reflected the likelihood that global economic activity would decelerate in 2019. Some commentators went even further, coining a new phrase, and posing the question of whether a “Japanification” of the global economy was taking place. That is, even a decade after the Global Financial Crisis, was the global economy caught in the same quagmire as post-bubble Japan: unable to shrug off deflationary pressures, and with growth habitually at stall-speed? Following a disappointing 2018, Europe has been the main target of this critique, especially as the Eurozone economy teeters on the brink of recession, despite the ECB’s ultra-loose monetary stance. But even the durability of US growth has been questioned. As the benefits of fiscal stimulus faded, was US growth reverting back to the lacklustre pace characterised as the “New Normal”?

For decades, the European economy has been inflicted by what was characterised as “Eurosclerosis”. Japanification, however, is a far more serious mallady. And, while many of the symptoms are similar, I believe that Europe (and especially the USA) are not inflicted with the more chronic Asian disease. The distinction will have important implications for financial markets. Nevertheless, following the upcoming Euro elections, European leaders should urgently implement reforms to prevent Eurosclerosis from morphing into a Japanification of the region’s economy!

Debt and Deflation: Balance Sheet Issues

Balance sheet issues lie at the heart of Japan’s three decades of post-Bubble, deflationary stagnation. First of all, Japanese corporate debt soared to 150% of GDP during the Bubble. During the past 30 years, a painful balance sheet deleveraging has succeeded in lowering business sector liabilities towards 100% of GDP.

In theory, there is no ideal level of corporate debt. And, many commentators have expressed concerns about the buildup of private sector leverage world-wide following the Global Financial Crisis. Even after its successful adjustment, Chart 1 above illustrates Japanese business liabilities remain elevated compared to other advanced economies. And, despite justifiable concerns about the historically high level of corporate borrowing in the United States, the level of business indebtedness remains well below Japan’s. Meanwhile, in contrast to Japan’s recent intense deleveraging efforts, European corporate debt rose steadily between 2000 and 2014. Since then, the region’s business leverage has remained steady, at levels similar to that found in Japan. With European interest rates low, a painful deleveraging campaign is unlikely in the immediate future.

In addition to the private sector, ballooning government debt has weighed heavily on Japan’s economic performance in recent decades. Again, there is no ideal level of public sector liabilities, but there’s evidence suggesting the deleterious impact intensifies once the ratio exceeds 100% of GDP. The Chart above illustrates Japan’s public sector debt ratio has not only soared, but is more than double that in the USA and Europe (which have both risen sharply).

In addition, important differences in future debt dynamics exist between countries. In Japan, importantly, the debt load will continue to rise until the government budget deficit is reduced by roughly another 2% of GDP (which fortunately is the government’s plan). Meanwhile, even though America’s debt is much lower, the ratio is set to rise meaningfully in coming years following the Trump Administration’s tax cuts. To be sure, European public finances will face numerous challenges in future decades. However, past austerity efforts have succeeded in capping the region’s government debt ratio at levels well below Japan’s.

However, liabilities are only half of the balance sheet. Of course, we are all well aware of the collapse in Japan’s post-bubble housing prices, which remain at roughly half of pre-crisis levels, and continue to haunt the pysche of Japanese consumers. The Chart above illustrates that European and American property quotes have risen 150% during this interval. Equity market values tell the same story, which emphasises the need to appreciate the distinctive nature of Japanification. Since peaking in 1990, Japan’s Topix remains 45% lower, while European and US bourses are up 265% and 315% respectively.

Slower Trend GDP Growth: Challenges World-Wide

The advanced economies all have experienced a significant slowdown in trend GDP growth in recent decades. And, the pattern appears to have intensified following th Global Financial Crisis. However, important distinctions exists between countries, and again Japan stands out in noteable ways.

Being simple people, economists look for simple ways to illustrate their points! In this regard, the causes of the slowing pattern of GDP growth can be attributed to trends in labour supply, productivity, and business investment (capital inputs). The Chart above illustrates the sharp deceleration in productivity growth in all the advanced nations following the GFC. Following a catch-up surge in the 1970-90 interval, Japanese efficiency has decelerated sharply thereafter. Productivity growth lagged the USA between 1990 and 2010. Japan’s better relative post-GFC performance largely reflects poor results in the USA, as Japanese efficiency gains continue to cool. Meanwhile, Japan kept pace with key European competitors (Germany, France, and UK) during the 1990-2010 period. However, despite its own slowing productivity, Europe has outpaced Japan since the GFC.

However, Japan’s productivity deficiency is most apparent when comparing the level of GDP per hour worked (Chart above). Japanese efficiency is only 60% that of American workers, and has lost ground in recent decades. Japanese labour also lags well behind key European counterparts, many of whom continue to narrow their gaps with the USA.

Meanwhile, all advance nations confront the demographic challenge of aging populations. However, the Chart above illustrates that not only is Japan’s population already older than US and European competitors, but the gap will widen in coming decades, which will add to pressures on public finances in all countries.

In terms of long-term GDP growth trends, reductions in the working-age population reduce the contribution to future growth of labour inputs. But, again, Japan stands out. The Chart above shows the work force is already contracting sharply, and these pressures are set to intensify. In Europe overall, labour inputs are still rising, but this will change in coming decades (already happening in Germany and Italy). However, the situation is not as dire as in Japan. And, while labour supply growth will slow also in the USA, relatively healthy demographics suggest labour inputs will still contribute to future GDP gains.

However, there are solutions to these demographic challenges. Immigration, for example, can add to labour supply. And, while Europe and the USA will need to define the future role foreign workers will play, both have far more liberal approaches than in Japan (despite recent Japanese reforms) — see Chart above. In Europe, surging birth rates in Africa present both challenges and opportunities. On the other hand, the participation of women in Japan’s labour force lags far behind Europe and the USA. If Japan can overcome cultural impediments, this could help ease demographic pressures.

Finally, trends in business investment influence potential GDP growth. The following Chart illustrates that global capital spending has declined as a percent of GDP in recent decades, but especially in Japan. Nevertheless, Japan’s investment ratio still exceeds that in most other advanced economies. In addition, Japan’s record on R&D and investment in intellectual property is good, although it lags well behind the USA in spending on information and communication technology.

Strategic Considerations

• Long-term trend GDP growth has downshifted throughout the advanced economies, reflecting flagging productivity, high debt, and adverse demographic patterns. Of course, not all countries are the same. US trend growth is 1.5-2%, Europe 1.25-1.5%, but Japan is only 0-0.5%.
• European leaders, however, should not be complacent. Japanification is still possible! Reform momentum has stalled. Following the upcoming Euro-elections, urgent action must be taken to reduce debt, boost productivity and business investment, and reform immigration policy.
• European equities trade at a huge discount to world market, reflecting some conern that Japanification has taken hold (Chart below). If economic recovery gains some traction this year, as I expect, European stocks should outperform.

• Abenomics is making a difference. Corporate cost-cutting has boosted Japan’s return on equity to pre-bubble levels. These improvements have not yet been reflected in equity valuations.