US Vs. Japan Redux? A Credit 'Compare And Contrast' From BofA's Jeffrey Rosenberg
Much has been said about the comparison between Japan and the US on a macro level, as both countries succumb to the deflationary forces of social-wide deleveraging. Yet few have analyzed the transition of the US into Japan from the perspective of corporate credits. Below is BofA's Jeffrey Rosenberg, arguably the firm's best analyst, sharing what he sees as the arguments "for" and "against" the credit markets on America's one way road to Japanification.
Is the US becoming Japan?
Arguments for and against in the credit markets
From the fixed income market perspective the obvious implication of turning Japanese would be a secular bull market in bonds. Such trends appear underway and the decline in rates validates the “Japanification” scenario. Amid the similarities however, critical differences in the structure of credit markets likely allow a greater transmission of monetary policy accommodation into the real economy, eventually. Recent signs point to this potential, though admittedly little of policy accommodation has reached the real economy and most of its inflationary consequences have resided in the financial economy.
Bull market in bonds belies “Japan” scenario
Exhibit A in the US as Japan scenario is the bull market in bonds. Figure 1 highlights the similarities between Japan interest rates after the bursting of its asset price bubbles in 1990 and the US post credit crisis. Extrapolating these trends makes it clear to us were the US to follow the road of Japan, a secular bull market in bonds and lower long-term interest rates would result.
Four lessons of Japan
Comparing the US and Japan on a macro economic basis reveals many similarities and differences. We repeat their “four lessons”: 1) Adopt an aggressive monetary policy response; 2) Heal the banking system quickly; 3) Avoid prematurely removing support; and 4) Ineffective policy can be expensive and lose popular support.
From the market perspective, the aggressive monetary support and the banking system response stand as the clearest differences between the US and Japan. Figure 2 depicts the relative shape of the yield curve between the US and Japan at similar points in time relative to the crisis. The consequence of the much more rapid monetary policy response relative to Japan has resulted in a much steeper yield curve. That steep yield curve in turn encourages a faster healing of the banking system in the US.
Faster healing of the banking system…
As our economists highlighted, the faster degree of recapitalization of the US banks (at least large US banks) contrasts to the extended period of “zombie” banks as Japan policy makers employed a strategy of regulatory forbearance. In the US, while residential and commercial real estate trends may most closely resemble this pattern, for corporate exposures the trends look decidedly more favorable in the US. For example, the recent Fed senior loan officer survey highlighted that both demand and supply for commercial credit in the US appear to be stabilizing.
…and less reliance on the banking system
Another critical difference between the US and Japan lies in the structure of their credit markets. In addition to the slow monetary policy response (lesson #1), the failure to address quickly the banking system (lesson #2) led to a failure of monetary policy transmission into the real economy. In Japan, the vast majority of credit flows through the banking system – both for consumers and corporates. In contrast, the US financial system underwent a dramatic period of disintermediation in the period leading up to the credit crisis as the growth of securitization and public bond markets gradually moved credit intermediation into the public arena and away from private (banks) balance sheets. Figure 3 on the previous page highlights the differences in credit disintermediation between Japan and the US.
Disintermediation allows greater flexibility for policy accommodation to work into the real economy. The record pace of issuance in corporate bonds for example illustrates how the corporate sector directly benefits from lower interest rates (Figure 4). For consumers, lower rates are now spurring another round of mortgage refinancing leading to lower interest expense for consumers (Figure 5).
And while little of that activity has yet made it into the real economy, the backdrop of both cash on balance sheet and credit market availability means that unlike in Japan, the ability to finance growth on corporate balance sheets does not stand as an impediment to any recovery. Similar to Japan however is the current lack of willingness – reflective of a lack of confidence in the business sector to spend. The rapid steepening of the yield curve in the US in contrast to Japan has led to a shift out the curve in investor demand for credit. This has allowed corporations to reduce the risk on their balance sheets by extending maturities of debt leaving balance sheets more rapidly repaired in the US case, putting US corporates in a better position to spend if confidence were to return to do so.
Credit likes disinflation…
Another implication of the Japan scenario for the US is the performance of credit assets. A consequence of the previously mentioned lack of disintermediation in Japan, most credit exposures rested on bank balance sheets. The policy of forbearance in recognition of bad assets meant that credit losses were deferred for years in the Japan scenario. This artificially lowered what reported and actual loss rates would have been under the deflationary environment of the time.
A look at the US history of deflation however yields a clue as to the potential performance of credit assets under a protracted period of falling prices. Unlike today’s current period of falling inflation (disinflation), declining rates and compression in credit spreads has led to asset class leading returns for credit.
…but hates deflation
Servicing fixed debts with declining revenues spells increasing credit risk. This fact is clearly borne out in the default experience of the US during the depression – the only sustained period of deflation in US history (Figure 6). Of course, the large increase in defaults was associated with large price declines. More modest deflation would be less negative for defaults but clearly as the figure suggests, the relationship of defaults to deflation is highly non-linear and a small increase in deflation could lead to large increases in corporate defaults. Moreover, as the overall price level falls the risk associated with further declines would likely lead to larger spread widening further undermining corporate performance.
All of this merely goes to show why futher QE is inevitable, as the Fed hopes that further tightening in Treasury spreads continues to bring corporate spreads in, forcing corporates to continue to refinance at record low rates. Yet the biggest problem, which nobody wants to address, is the decreasing prevalence of cash-flow generating assets. As this most scary phenomenon is appreciated more and more by the investing community, the rates on debt will not matter, as no matter how close to zero these get, the record corporate debt overhang (yes, it goes hand in hand with the overhyped cash on the sidelines), just like USTs, will never be repaid. Case in point: the reemergence of 100 Year bonds (and the surprising willingness of investor to bid these up).