Europe and Japan are two immensely popular areas of investment at the moment and it’s not difficult to see why.
Since the start of the year, the Nikkei 225 has achieved returns of over 20 per cent, pipping many other markets to the post including the MSCI World Index.
Performance of indices since 2015
Source: FE Analytics
Japan’s introduction of Abenomics at the end of 2012 has helped pave the road to recovery for the once economically sluggish country and almost half of the top 10 performing funds of 2015’s first quarter were Japan funds, according to data from FE Analytics.
Europe has also been climbing in the popularity stakes recently, following European Central Bank president Mario Draghi’s introduction of quantitative easing (QE) earlier in the year.
A global analyst survey conducted by Fidelity last week revealed that companies in developed markets scored much higher on confidence, returns and balance sheet strength. The report found that Japan achieved the highest ‘global sentiment score’ of 7.1 points, followed closely by Europe at 5.8.
But Toby Hayes, who manages Franklin Templeton’s Diversified Growth and Diversified Income funds, doesn’t see a lot of appeal in either market at the moment.
“QE is obviously a big story and has been for the last five years,” he said. “There has been a huge amount of liquidity in Japan, a huge amount of QE has been done, and what we’ve seen in terms of inflation rates in Japan has been negligible.”
“There has been no effect on inflation and this was really the stated plan. The idea of Japanese QE was that they would buy the bond markets and currency markets would get pushed down, the equity markets would rally, and this certainly has happened.”
Japan’s huge QE operation, which scale-wise is 10 times the size of the US’ QE programme, involves injecting ¥80trn every year into the economy.
In an FE Trustnet article last month, FE Alpha Manager Chris Taylor, who runs the Neptune Japan Opportunities fund, said that this move was necessary to continue to boost the economy, adding that Japan is not planning to take its foot off the gas any time soon.
However, while Hayes acknowledges that QE has boosted the equity market, he sees trouble on the horizon.“The next stage [after QE] was that the Japanese corporates and exporters would get a lot of cash because the currency would do down. That happened as well, so that’s one of the reasons why the Japanese equity market has done so well,” he said.
“The third stage of the plan was that these Japanese corporates would suddenly pay higher wages to their workers, then the workers would consume more and that would start natural growth within the economy. The consumers get paid more, buy more stuff and kick-start the economy.”
“The problem is, this hasn’t worked. That didn’t start – they haven’t really done any wage increases for their workers. And, at the same time, the consumer in Japan has been hit because currency has gone down and everything that’s imported has suddenly shot up in price.”
Hayes believes the import inflation that Japan witnessed has not necessarily done the Japanese economy any favours as product pricing has increased but the consumer’s wage has stayed the same, creating what he referred to as a “living crisis”.
“[The inflation] hasn’t kick-started growth in the economy and what’s more, it’s caused a few issues in the bond market,” the manager continued.
“Bond market liquidity is drying up. The Bank of Japan is effectively buying the entire bond market and they arguably have ‘crossed the Rubicon’ into debt monetisation.”
Japan’s $1.2trn pension fund for Japanese public sector employees, the GPIF, re-allocates assets in whichever way the BoJ chooses.
Hayes says the fund’s decision to allocate from bonds has created a nation of ‘forced sellers’ and that the BoJ is buying a massive amount of these bonds.
Despite this denting the liquidity of the bond market, Hayes does see it as a small positive for Japan.
“Say if you own a bond and you were to sell your bond to the bank of Japan, you could then deposit your cash at the Bank of Japan and get 10 basis points,” he explained.
“Okay, it’s not a huge amount, but it’s at least something. They fact that they’ve got a ‘forced seller’ in Japan is at least some incentive to hold cash with the Bank of Japan.”
However, Hayes notes that the Bank of Japan is struggling to buy all of the bonds that it wants to.
The manager sees Europe as an even less appealing investment prospect than Japan, as he thinks that the ECB will encounter a similar buffer. He adds that there is no rigid structural system in place and consumers are free to invest as they please, causing greater concern.
He said: “This is one of the macro worries we have coming up in 2016: there’s no ‘forced seller’ in Europe. They have to expand their balance sheet and they have to buy all these bonds, and I think they will struggle to get invested.”
“If you were a German bank and you were to sell your bank bond to the ECB, you would have to go and deposit at a negative rate, so you’d earn negative rates on your cash. There’s no incentive for many holders of bunds to sell.”
Hayes, however, accepts that QE has driven the European and Japanese markets, and is not an ineffective way to enhance the economy.
However, his big worry is that it won’t lead to a lasting improvement in either country.
This is a large macro worry that he and his team have for later in the year, if some of the QE trade reverses.
“In terms of Europe as a region, we do unfortunately think it is a deflationary enterprise,” he said.
“The QE will give some relief without a shadow of a doubt, but the problem with Europe is they tied in high-inflation economies with low-inflation economies. Usually, in a normal world where two economies are high inflation and low inflation and they meet, the exchange rate adjusts. Because there’s no exchange rate adjustment, what happens is wage levels adjust and unemployment adjusts. This is what we’ve been seeing in the periphery.”
“That’s been disguised by a huge credit boom. Now that credit boom is over there’s a double hangover and this was why they tried to do QE – to kick-start the European economy out of its flunk. But, the experience with Japan is that it hasn’t worked in terms of giving that growth.”
“We’re not convinced this will work and that Europe will simply bounce back to ‘sunny and pleasant land’. It will give a temporary boost but I don’t think it will leave a long permanent boost to the European economy.”