Ian Gordon is a bear’s bear. The Vancouver-based market historian is famous for predicting the Dow will drop to 1,000 before the Great Recession ends. So when the former British Cameronians (Scottish Rifles) platoon commander says he’d buy stocks in the world’s second-largest economy, investors might want to take his words as marching orders. Then again, Gordon — who moved to Canada in 1967 — isn’t exactly bullish on Japan. That’s just where he tells people he’d invest if someone held a gun to his head, because he believes spring-like growth cycles always follow long economic winters, “and Japan has been shovelling snow a lot longer than other places.”
True enough. Thanks to the Lost Decade, many market players typically approach Japanese equities like movie scientists approach Godzilla. In other words, as soon as things look safe, macroeconomic and political forces show their teeth and scare them off. Nevertheless, stock prices have been on the rise in the Land of the Rising Sun, where — fuelled by its longest winning streak in more than 20 years — the benchmark Nikkei 225 index broke 10,000 in July.
More than madness is at work. As Bill Witherell, chief economist of New Jersey–based Cumberland Advisors, noted in a commentary that warned investors not to ignore the world’s second-largest equities market, Japan has been fighting the most severe downturn in its postwar history because of a strong currency and a crash in exports. When it comes to real estate valuations and leverage at financial institutions, it was in relatively decent shape when the global credit crisis hit. But any Japanese bull will eventually face off against monstrous debt, according to John Mauldin, a Texas-based adviser to the very wealthy, who makes a case for long-term thinkers to avoid “the Land of the Setting Sun.”
Remember the mid-1990s, when The Wall Street Journal named Canada an “honorary member of the Third World” thanks to a debt-to-GDP level of 101.7% (including all institutions in the general government sector). Well, after advising readers of his Thoughts from the Frontline e-newsletter to pour themselves “a nice adult beverage,” Mauldin recently pointed out Japan’s total public debt now sits around ¥900 trillion ($10.1 trillion) because its government started running massive deficits to deal with bubbles in local stocks and real estate that popped in 1989. And the overspending never stopped.
Over the past decade, Japan’s debt-to-GDP level has jumped to more than 170%, from below 100%. And that’s not counting debts held by local governments. All in, according to IMF data, the debt-to-GDP figure breached 200% in 2008 and will top 225% in 2010. (Canada’s debt sat around 60% of GDP at the start of this year. In the U.K., the number was 50%. The United States’ accumulated fiscal shortfall was 68.7% of GDP at the start of the year. Even with Washington’s deficits, the U.S. debt-to-GDP level isn’t expected to hit 100% for half a decade or more.)
In the past, Japanese savings helped keep interest charges on the debt around 1%. “As late as 1999,” Mauldin notes, “personal savings plus pensions were running at 12% and had been as high as 16%. And much of those savings went into government debt. The government kept borrowing, and rates stayed in the area of 1%. Today, a 10-year bond yields 1.3% in Japan, so they could run up a very large debt and the interest-rate cost was not a big factor in the budget.” But the landscape is changing. “Japan is a rapidly aging nation,” Mauldin explains. “The population is shrinking, and the birth rate is among the lowest in the world. And the dependency ratio is starting to rise.” There are 1.2 non-productive Japanese citizens (under 15 years old and over 64) for every productive one. The ratio will be two-to-one by 2020 and keep growing from there. With more retirees, Japanese savings are headed for negative territory. They have already dropped to 1.8%, from about 18% in 1991.
Raising taxes isn’t a productive option. And Japan is currently borrowing 30%–40% of its annual budget. Interest expense on the national debt sits around 18%. So far, there has been no collapse in government-bond prices or a surge in yields. But the nation will issue IOUs worth at least ¥33 trillion ($371.6 billion) this year, when national annual net savings have fallen to just ¥5 trillion ($56.3 billion). Japan now needs to compete for foreign investors in a global buyer’s market, supplied by politicians looking to finance deficit spending worth about US$5 trillion (almost 9% of world GDP last year) in 2009. And if rates rise by just 1%, Mauldin says interest alone could eat 100% of tax revenues in less than 10 years.