Japan is finally coming back into the limelight – for all the wrong reasons...

The third-largest economy in the world has largely flown under the radar for the past three decades.

Back in the late 1980s, the country looked set to overtake the U.S. economy. It had some of the best and biggest tech companies. Its cars were gaining a reputation for great quality.

Unfortunately, that was the end of the road for Japan. It was hit with several challenges that led to its sudden crash. Since then, it has all but faded from public interest.

In the U.S., a lot of companies still maximize value for shareholders specifically.

Meanwhile, Japanese industry has long focused on stakeholder capitalism as opposed to shareholder capitalism. That means all business stakeholders, including employees, are considered.

Add to that an aging population and a growing number of "zombie" companies (those that can't afford the interest on their debt)... and you get a recipe for crippled growth.

Japan's Nikkei 225 Index hit an all-time high in 1989. It hasn't returned to those levels in more than 30 years.

Japan has largely been an afterthought of many equity investors and economists. However, as we'll cover today, the country may have been behind the recent market rally in the U.S.

And based on what's happening behind the scenes, investors should take care not to get complacent...

Low interest rates are catching up to the world...

Japan has faced decades of deflation issues due to its aging population. The country has more elderly citizens than anywhere else in the world.

Even as the rest of the world battles surging inflation, levels in Japan have yet to break 4% in the past few years.

In the U.S., the Federal Reserve has been raising interest rates to cool things down. It's the opposite story in Japan... In order to stimulate the economy and encourage spending, the Bank of Japan ("BoJ") is relying on quantitative easing ("QE").

We talked about QE back in December. Put simply, central banks try to help stimulate the economy by increasing the money supply.

To do this, they buy their government's bonds or other financial assets from banks. That gives the banks more money to lend out to people and businesses. The goal is to help boost spending and economic growth.

Now that inflation is peaking, the question for investors is whether Japan can handle all that debt. That's especially true as interest rates have jumped higher for Japanese bonds, climbing from 0.28% in December to 0.5% for most of January.

Higher interest rates increase the amount required for coupon payments on Japanese government bonds. This, in turn, puts pressure on the Japanese government.

Plus, Japanese government bonds represent more than 250% of Japanese gross domestic product ("GDP"). For reference, Italy is the normal developed-market "boogeyman" for government credit issues. It's liable for around 150% of GDP in bonds.

With Japan's obligations getting so high, activists are entering the bond market. Basically, they're investors who sell government bonds to put pressure on governments.

This happened last October in England, when former U.K. Prime Minister Liz Truss' cabinet proposed historic borrowing increases. Now, it's happening in Japan.

Bond vigilantes aggressively sold Japanese government bonds late last year and early this year... sending yields higher than the BoJ wanted.

To keep yields in check, the BoJ went back to its favorite tool...

In a show of what is effectively more QE, Japan's central bank started buying up bonds at the start of the year. It bought a record ¥3.2 trillion of bonds in a single day to keep yields down.

That's an enormous amount of cash being pushed into the economy.

The extra liquidity from QE tends to end up in risky assets like equities. Some of that additional cash has ended up in the Nikkei, which is up about 5% in 2023.

Remember, the Nikkei still hasn't recouped its reputation from the 1980s. So it's likely that even more of that cash ended up in high-growth indexes... including the S&P 500 Index, which is up 6% so far.

The issue is that many investors see the rally differently than we do. Folks are getting excited that inflation is cooling down. They think the Fed is getting ready to slow down its rate-hike program.

We disagree. In our view, the rally to start the year may have more to do with investors chasing after good news than real market fundamentals.

As we explained yesterday, the Fed still has to deal with historically low unemployment. The economy isn't pointing to rocket-ship growth anytime soon.

It can be tempting to buy whenever the market has a bit of momentum. Resist that urge. Our advice is to stay tactical in the coming months... It's unlikely to be a smooth ride up.


Joel Litman
January 31, 2023