Submitted by Eric Peters, CIO of One River Asset Management
“Hmmm,” said the former central banker, leaning back in a chair. I’d asked how his thinking on the meaning of money had changed over these last three decades. We both started this journey in 1989, and our paths somehow led us to this long table in Tokyo. In that time, much changed. Back then, Japan’s gov’t debt-to-GDP was roughly 50%, 10yr JGB yields were 5%, the dollar was worth 127 Yen. But now, debt/GDP is roughly 250%, the central bank has printed enough money to buy half of it, 10yr yields are -0.07%, the Yen has strengthened to 109.
"You are correct, as a young man I would have never imagined this would be our destination," he said, after some consideration. “And I am trying to think about how my views changed over so many years, because I cannot recall a moment when I realized everything was not as I had previously understood,” he said. "Perhaps, over such a long span of time our thinking gradually evolves, and we’re not aware that it has." I nodded, quietly considering my long wander. "But here we are, and while I do not understand it perfectly, it makes some sense."
We were discussing equity markets over sushi. America’s has had an extraordinary run. In the 30yrs from Japan’s 1989 Nikkei high, the S&P 500 gained 925%, and from the 2009 GFC crisis lows the S&P 500 gained 464%. The Nasdaq gained 1,948% since 1989 (+655% from 2009 low). They say the reason for this recent extraordinary march is the Fed’s QE and a policy of low rates that has combined to push America’s CEOs to buy back stock, while forcing global investors to pay any price for growth in an ageing economy, where growth is scarce.
“I suppose that explanation for America’s bull run makes sense in isolation,” said the CIO in Tokyo. But Japanese rates are -0.10%. The BOJ printed enough money to make an Italian central banker blush and continues buying stocks directly on the open market. Japan is the ultimate ageing economy, with slow growth, world-class technologists, researchers, and plenty of entrepreneurs. “Investors have come to accept that overall explanation without reservation. Yet, if it is true, how can it also be true that the Nikkei remains 40% below its 1989 high?”
The Japanese work culture is notorious for its long hours. Microsoft Japan conducted an experiment in August with 2,300 workers. It paid them to not work on Fridays. It encouraged online chats in place of meetings or emails. It insisted meetings include five people or fewer and last no longer than 30mins. Microsoft saw a 40% increase in sales/worker, a 59% decline in paper usage, and a 23% drop in electricity consumption. Asked what day employees would like off if the firm moves to a 4-day workweek, 50% answered Wednesday.
The dynamism in Japan’s economy is not to be found in the conglomerates,” said the CIO, focused on small cap stocks. “To find the interesting companies, you must look at the small and mid-sized firms that supply the large players – they’re the ones where you find the creativity, the risk takers, innovators.” Japan spends 3.5% of GDP on Research & Development, the US spends 2.8% and China 2.0%. Only South Korea spends a larger percentage of its GDP on R&D (4.3%). “The very big firms here have grown to resemble state owned enterprises.”
“We move slowly here,” said the executive, chain smoking Seven Stars. “We have refined the art of flawless production,” he explained. “But there was a time when it was not so.” Two Asahi Extra Dry’s arrived, the thick foam head in each glass identical, poured deliberately, in perfect proportion, beautiful beer. “We once copied the chemical compounds designed in America,” he admitted. “As we amassed knowledge, we developed our own, and accumulated manufacturing know-how, capital.” In the distance, Japan’s factories spewed smoke, but at a pace that made the past appear more frantic than the present. “We produced chemicals and materials for the world to incorporate into nearly every product, and in pursuit of perfection, we introduced quality controls. Then controls on controls. And controls on controls on controls, ensuring that our final output was flawless.” The executive smiled, drawing deeply, his wrinkled face aglow. “But this pursuit of perfection slowed our ability to develop new compounds. And now the Chinese outpace us. They copy our formulas as we once copied yours. They produce at a pace that ensures higher impurities, but greater throughput, wider margins. And without having to bear the costs of R&D investment, they slash prices savagely.” The executive lit another Seven Star, turned his head slowly, exhaled. “The Chinese test their compounds with scant regard to safety. Then iterate again and again. Racing to produce compounds that may not be great but are perhaps good enough. They scale production overnight. They do what they must to capture market share,” he said, growing quiet, contemplative. I matched his silence, waiting for him to fill the void. Across the world’s third largest economy, the mighty conglomerates lumbered onward, industrial inertia. "And while we know this, and see this all unfolding, we appear unwilling to respond, unable to change course, accelerate."