Japan emerges from the shadows: over a decade of Abenomics and the end of deflation

Description

In this episode of ThinkMacro, Vincent Chailley, Chief Investment Officer (CIO) of H2O AM Group, explores the transformation of Japan’s economy after three decades of deflation and stagnation. He traces the country’s evolution from the 1980s bubble collapse through Abenomics reforms to today’s return of sustainable, organic growth. The episode examines how deep structural changes in labor markets, governance, and fiscal policy have reshaped Japan’s economic foundations, while analysing the implications for interest rates, currency dynamics, and financial markets. The key message: Japan has finally escaped deflation, but investors should expect a very different macro environment ahead.

This podcast is distributed for informational purposes only and does not constitute advice, an offer or solicitation by or on behalf of H2O AM to buy or sell any securities, related financial instruments or other products, or to engage in any trading strategy in any jurisdiction. The analyses and opinions contained in this document represent the views of the author(s) referenced as of the date indicated and are subject to change without notice.

Before investing in any product, investors should fully understand the risks, including the market risk associated with the issuer, the financial benefits and the suitability of such products, and consult their own advisors. Investors should be aware that the value of an investment and the income derived from it may fall as well as rise, and that past performance is not a guide to future performance.

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Transcription

Speaker #0
Hello everyone and welcome to a new episode of Think Macro where today I would like to talk about Japan. Until recently the Japanese economy had been stagnating, aging population, 30 years of deflation, but over the past 15 years Major reforms have been undertaken and they're beginning to bear fruits. Growth is returning. The country is reclaiming its place in global competition. And because these reforms are deep and comprehensive, it should be able to maintain that position for some time. But, and this is an important but, the consequences for assets will likely be very different from what we've experienced in the past. To imagine what may happen next, let's take a step back. After the bursting of the 1980s bubble, the country fell into the quicksand of deflation, a trap that is always long and difficult to escape. In the early years, targeted measures were attempted. Fiscal stimulus, zero interest rates, and even as the first country to do so in 2001, quantitative easing. But these interventions were perceived as temporary gestures with only short-term impact. They anchored in people's minds the idea that it was better not to move so as not to sink further into the quicksand. It was better to consume or invest tomorrow rather than today since prices were falling and stimulus measures only revived the economy briefly. And so the economy became paralyzed. After 20 years under this regime, in 2012, Shinzo Abe, a newly appointed prime minister, understood that action had to be decisive and, above all, comprehensive. He launched deep structural reforms, public sector reform for the state, major infrastructure projects, simplified governance and free trade agreements for businesses. incentives for women and older workers to join the workforce, and greater openness to immigration to offset the structural decline in labour supply. One must imagine the profound cultural shift in a country where, at the time, women's participation in the workforce was poorly regarded and immigration was so limited it was barely even a topic of debate. But Abbe knew that mindsets also had to change, that this shock treatment had to transform not only the structure of the economy, but also the culture of the country. To support these long and difficult changes, he used the tools at his disposal, a large fiscal plan, an ally at the head of the central bank, who would lower rates further, massively purchase government bonds, and explicitly target a return to inflation. Deficits widened further, and the independence of the central bank was somewhat weakened, but such measures were necessary to revive the country and escape the deflation trap. Ten years of Japanese discipline later, some results began to appear. The gap between male and female employment was nearly halved. Corporate investment, which had stagnated for 20 years, began to rise again. The country opened up to immigration. Tourism boomed. Corporate margins increased and the stock market surged. It tripled during Shinzo Abe's eight years in office, after 20 years of continuous decline. Yet, despite all this, mindsets remained stuck in the it-will-be-better-tomorrow mentality, and deflation persisted. In the end, It was the inflation shock of 2022 that changed attitudes because it was a global shock, longer and deeper than expected, because it severely eroded purchasing power in Western countries. It frightened the Japanese. It finally convinced them to prefer the present over the future. Corporate investment accelerated. Consumption rebounded. and the enormous capital accumulated over thirty years was put to work, and since there was no desire, To kill the recovery in its infancy, the central bank remained a commodity for much longer than elsewhere. The first rate hike came in early 2024, two years later, after ensuring that the economy engine was truly running again. At last, growth became organic and self-sustaining, functioning without artificial stimulus. Beyond the exit from deflation, the Abenomics reforms, particularly labour market liberalisation, restored productivity to the economy and offset part of the demographic decline. Japan has regained potential for sustainable growth, running counter to the slowdown in the United States. Companies are now beginning to reap the rewards of Abenomics. Margins have tripled and reached historic highs, not far from European and even American levels. Productivity is rising again after 20 years of stagnation, without losing market share to China, unlike other developed countries. All the books are full, both domestically and for exports. And this solid momentum is now being amplified by strong growth in neighboring countries, benefiting from the boom in AI-related investments. We're seeing a return of the mechanisms that characterized the golden age of the 80s. Profits should continue to grow much faster than inflation. High public debt is often cited as a constraint or a risk to the sustainability of the recovery. It is true that significant spending was required to implement those reforms, as well as for the largely ineffective measures of the early years. But in reality, there's no real problem. It's largely an accounting illusion. Japan is less indebted that it appears. The state, which in conventional measures shows gross debt of more than twice GDP, in fact, has a net debt of around 110%, lower than in the United States or France, because the Japanese government holds a considerable amount of assets. that must be netted out of its balance sheet. And unlike in other developed countries, this debt is declining, thanks to sound fiscal management and negative real interest rates. The same conclusion applies to households and companies. At two-thirds of GDP, household debt is below the average of developed countries and has not changed in 30 years. Corporate debt is slightly higher because they... Companies have invested heavily, but at 45% of GDP, fears of bankruptcy are unfounded. There's no risk on the debt front. And that's not all. The Japanese themselves hold massive amounts of foreign assets, around 90% of GDP in 2025. This is a mirror image of the U.S. deficit and one of the highest positions in the world, nine times Europe's. four times China's, while Anglo-Saxon countries that like to develop on credit are generally net debtors. This gigantic portfolio of foreign assets shields Japan from any risk related to its debt and puts it in a position of strength in a world where others, led by the United States, must fight to attract capital to finance their deficits. The conclusion is that the Japanese economy has exceeded deflation for good and is now expanding on all fronts. But for financial assets, it will be a different story. Because growth is once again organic and not merely the result of temporary stimulus, the implications will be very different. Today, the market, still looking in the rearview mirror, expects a repeat of past performance, a kind of epinomics 2.0. rising equities, lower rates and a weak currency. It's wrong, perhaps on all three counts. First, interest rates and the currency no longer have any reason to stay low. It is no longer necessary and is even becoming counterproductive. Looking at interest rates while maintaining an ultra-accommodative monetary policy for longer than elsewhere helped secure the autonomy of the recovery, it has also led over the past two years to a sharp steepening of the yield curve, which is becoming problematic. This trend cannot be allowed to continue without risking a loss of control. Long-term rates reflect both debt servicing costs and inflation expectations. The higher long-term rates rise, the more difficult it becomes to service the debt, and the more economic agents fear that inflation may become entrenched, that it may have become acceptable. The rise fuels the rise. Letting long-term yields drift higher would risk pushing the country from a deflation trap into an inflation spiral. This must be avoided at all costs. Policymakers need to provide assurances of discipline, calm concerns by raising policy rates swiftly, and thereby flatten the curve. In contrast to the West, the Bank of Japan will raise rates this year probably several times. The era of zero rates is truly over, even in Japan. Second, these rate hikes will lead to a stronger yen by reducing the cost of hedging currency risk. 18 months ago, that cost was over 5% against the dollar. We're earning around 5.25% in the United States versus zero in Japan. The differential will fall below 2% this year. And we know this is an important threshold that will trigger. significant currency hedging by institutions that are currently heavily exposed to the dollar risk. Now, beyond interest rates, a weak yen is no longer just unnecessary, it is becoming harmful for several reasons. First, because the capital of Mises Watanabe, the archetypal Japanese retail saver, put back to work by Abenomics, has largely flowed abroad. with performance boosted by the yen's long-term depreciation. That was fine, as long as the yen kept falling, and US equity investments were both more profitable and less risky. But now that those assets are expensive, riskier, and less protected by the erratic behavior of the dollar, such investments make less sense. And that capital could be very useful at home, where many investments still need financing. For instance, the much-needed robotization to compensate for the demographic decline, allowing the yen to appreciate would encourage a healthy and productive repatriation of capital. There's a second, more economic reason to favor stronger yen commodities. Japan is a major importer, and a weak yen drives up the bill. That was not a problem for 15 years of low oil prices and stable metals. But prices are rising again. The appreciation of the past 12 months has been costly, and it could continue, fueled by the boom in AI investment. Yen weakness amplified the impact of the energy crisis after Russia's invasion of Ukraine in 2022, which hurt Japan badly. This time, caution is warranted. And finally, there's a mechanical reason. Japanese companies have invested heavily in overseas production capacity and have thus reduced their sensitivity to exchange rates. Toyota or Honda, by producing exports, they call locally in the United States, in France or the United Kingdom, no longer fear a stronger yen. Now that these investments are complete and productive, they are less necessary. the profits they generate and are repatriated are increasing. There are fewer outbound flows and more inbound ones. In fact, inbound flows are now beginning to dominate. Companies that contributed significantly to the yen's depreciation since 2012 are gradually becoming buyers of the currency, helping to drive its appreciation. And that's good news for them. Corporate balance sheets show that Profit sensitivity to a weak yen, a strongly positive 15 years ago, is now negative. Companies now benefit from a stronger yen. Now, in summary, investors, the state and corporations all have a growing interest in a stronger yen, and they will soon contribute to its appreciation themselves with a discount of more than 50%. The upside potential is enormous and will catch a market off guard that has yet to grab the depth of Japan's transformation. The few investment flows seen in recent months suggest that some are beginning to ask the question. That leaves equities. Fundamentally, renewed profit growth, regional performance, and the growing risks of the U.S. alternative argue in favor of buying them. And if a stronger yen is no longer a threat, why hold back? But investors have already largely priced in future growth. The index trades at 24 times earnings, almost as expensive as the US market, and 40% higher than before the COVID crisis. There's also a large speculative position in the Nikkei by foreign hedge funds, which are unlikely to stay invested if volatility rises, as is likely this year. That argues for waiting for market turbulence to access better entry point. We would recommend to... wait for that moment to build up the investment in the region. Thank you for listening. And I look forward to seeing you very soon for another episode of Think Macro. If you enjoyed this episode, please subscribe and let us know your thoughts and any topics you'd like us to explore next.

Description

Hosted on Ausha. See ausha.co/privacy-policy for more information.

Transcription

Speaker #0
Hello everyone and welcome to a new episode of Think Macro where today I would like to talk about Japan. Until recently the Japanese economy had been stagnating, aging population, 30 years of deflation, but over the past 15 years Major reforms have been undertaken and they're beginning to bear fruits. Growth is returning. The country is reclaiming its place in global competition. And because these reforms are deep and comprehensive, it should be able to maintain that position for some time. But, and this is an important but, the consequences for assets will likely be very different from what we've experienced in the past. To imagine what may happen next, let's take a step back. After the bursting of the 1980s bubble, the country fell into the quicksand of deflation, a trap that is always long and difficult to escape. In the early years, targeted measures were attempted. Fiscal stimulus, zero interest rates, and even as the first country to do so in 2001, quantitative easing. But these interventions were perceived as temporary gestures with only short-term impact. They anchored in people's minds the idea that it was better not to move so as not to sink further into the quicksand. It was better to consume or invest tomorrow rather than today since prices were falling and stimulus measures only revived the economy briefly. And so the economy became paralyzed. After 20 years under this regime, in 2012, Shinzo Abe, a newly appointed prime minister, understood that action had to be decisive and, above all, comprehensive. He launched deep structural reforms, public sector reform for the state, major infrastructure projects, simplified governance and free trade agreements for businesses. incentives for women and older workers to join the workforce, and greater openness to immigration to offset the structural decline in labour supply. One must imagine the profound cultural shift in a country where, at the time, women's participation in the workforce was poorly regarded and immigration was so limited it was barely even a topic of debate. But Abbe knew that mindsets also had to change, that this shock treatment had to transform not only the structure of the economy, but also the culture of the country. To support these long and difficult changes, he used the tools at his disposal, a large fiscal plan, an ally at the head of the central bank, who would lower rates further, massively purchase government bonds, and explicitly target a return to inflation. Deficits widened further, and the independence of the central bank was somewhat weakened, but such measures were necessary to revive the country and escape the deflation trap. Ten years of Japanese discipline later, some results began to appear. The gap between male and female employment was nearly halved. Corporate investment, which had stagnated for 20 years, began to rise again. The country opened up to immigration. Tourism boomed. Corporate margins increased and the stock market surged. It tripled during Shinzo Abe's eight years in office, after 20 years of continuous decline. Yet, despite all this, mindsets remained stuck in the it-will-be-better-tomorrow mentality, and deflation persisted. In the end, It was the inflation shock of 2022 that changed attitudes because it was a global shock, longer and deeper than expected, because it severely eroded purchasing power in Western countries. It frightened the Japanese. It finally convinced them to prefer the present over the future. Corporate investment accelerated. Consumption rebounded. and the enormous capital accumulated over thirty years was put to work, and since there was no desire, To kill the recovery in its infancy, the central bank remained a commodity for much longer than elsewhere. The first rate hike came in early 2024, two years later, after ensuring that the economy engine was truly running again. At last, growth became organic and self-sustaining, functioning without artificial stimulus. Beyond the exit from deflation, the Abenomics reforms, particularly labour market liberalisation, restored productivity to the economy and offset part of the demographic decline. Japan has regained potential for sustainable growth, running counter to the slowdown in the United States. Companies are now beginning to reap the rewards of Abenomics. Margins have tripled and reached historic highs, not far from European and even American levels. Productivity is rising again after 20 years of stagnation, without losing market share to China, unlike other developed countries. All the books are full, both domestically and for exports. And this solid momentum is now being amplified by strong growth in neighboring countries, benefiting from the boom in AI-related investments. We're seeing a return of the mechanisms that characterized the golden age of the 80s. Profits should continue to grow much faster than inflation. High public debt is often cited as a constraint or a risk to the sustainability of the recovery. It is true that significant spending was required to implement those reforms, as well as for the largely ineffective measures of the early years. But in reality, there's no real problem. It's largely an accounting illusion. Japan is less indebted that it appears. The state, which in conventional measures shows gross debt of more than twice GDP, in fact, has a net debt of around 110%, lower than in the United States or France, because the Japanese government holds a considerable amount of assets. that must be netted out of its balance sheet. And unlike in other developed countries, this debt is declining, thanks to sound fiscal management and negative real interest rates. The same conclusion applies to households and companies. At two-thirds of GDP, household debt is below the average of developed countries and has not changed in 30 years. Corporate debt is slightly higher because they... Companies have invested heavily, but at 45% of GDP, fears of bankruptcy are unfounded. There's no risk on the debt front. And that's not all. The Japanese themselves hold massive amounts of foreign assets, around 90% of GDP in 2025. This is a mirror image of the U.S. deficit and one of the highest positions in the world, nine times Europe's. four times China's, while Anglo-Saxon countries that like to develop on credit are generally net debtors. This gigantic portfolio of foreign assets shields Japan from any risk related to its debt and puts it in a position of strength in a world where others, led by the United States, must fight to attract capital to finance their deficits. The conclusion is that the Japanese economy has exceeded deflation for good and is now expanding on all fronts. But for financial assets, it will be a different story. Because growth is once again organic and not merely the result of temporary stimulus, the implications will be very different. Today, the market, still looking in the rearview mirror, expects a repeat of past performance, a kind of epinomics 2.0. rising equities, lower rates and a weak currency. It's wrong, perhaps on all three counts. First, interest rates and the currency no longer have any reason to stay low. It is no longer necessary and is even becoming counterproductive. Looking at interest rates while maintaining an ultra-accommodative monetary policy for longer than elsewhere helped secure the autonomy of the recovery, it has also led over the past two years to a sharp steepening of the yield curve, which is becoming problematic. This trend cannot be allowed to continue without risking a loss of control. Long-term rates reflect both debt servicing costs and inflation expectations. The higher long-term rates rise, the more difficult it becomes to service the debt, and the more economic agents fear that inflation may become entrenched, that it may have become acceptable. The rise fuels the rise. Letting long-term yields drift higher would risk pushing the country from a deflation trap into an inflation spiral. This must be avoided at all costs. Policymakers need to provide assurances of discipline, calm concerns by raising policy rates swiftly, and thereby flatten the curve. In contrast to the West, the Bank of Japan will raise rates this year probably several times. The era of zero rates is truly over, even in Japan. Second, these rate hikes will lead to a stronger yen by reducing the cost of hedging currency risk. 18 months ago, that cost was over 5% against the dollar. We're earning around 5.25% in the United States versus zero in Japan. The differential will fall below 2% this year. And we know this is an important threshold that will trigger. significant currency hedging by institutions that are currently heavily exposed to the dollar risk. Now, beyond interest rates, a weak yen is no longer just unnecessary, it is becoming harmful for several reasons. First, because the capital of Mises Watanabe, the archetypal Japanese retail saver, put back to work by Abenomics, has largely flowed abroad. with performance boosted by the yen's long-term depreciation. That was fine, as long as the yen kept falling, and US equity investments were both more profitable and less risky. But now that those assets are expensive, riskier, and less protected by the erratic behavior of the dollar, such investments make less sense. And that capital could be very useful at home, where many investments still need financing. For instance, the much-needed robotization to compensate for the demographic decline, allowing the yen to appreciate would encourage a healthy and productive repatriation of capital. There's a second, more economic reason to favor stronger yen commodities. Japan is a major importer, and a weak yen drives up the bill. That was not a problem for 15 years of low oil prices and stable metals. But prices are rising again. The appreciation of the past 12 months has been costly, and it could continue, fueled by the boom in AI investment. Yen weakness amplified the impact of the energy crisis after Russia's invasion of Ukraine in 2022, which hurt Japan badly. This time, caution is warranted. And finally, there's a mechanical reason. Japanese companies have invested heavily in overseas production capacity and have thus reduced their sensitivity to exchange rates. Toyota or Honda, by producing exports, they call locally in the United States, in France or the United Kingdom, no longer fear a stronger yen. Now that these investments are complete and productive, they are less necessary. the profits they generate and are repatriated are increasing. There are fewer outbound flows and more inbound ones. In fact, inbound flows are now beginning to dominate. Companies that contributed significantly to the yen's depreciation since 2012 are gradually becoming buyers of the currency, helping to drive its appreciation. And that's good news for them. Corporate balance sheets show that Profit sensitivity to a weak yen, a strongly positive 15 years ago, is now negative. Companies now benefit from a stronger yen. Now, in summary, investors, the state and corporations all have a growing interest in a stronger yen, and they will soon contribute to its appreciation themselves with a discount of more than 50%. The upside potential is enormous and will catch a market off guard that has yet to grab the depth of Japan's transformation. The few investment flows seen in recent months suggest that some are beginning to ask the question. That leaves equities. Fundamentally, renewed profit growth, regional performance, and the growing risks of the U.S. alternative argue in favor of buying them. And if a stronger yen is no longer a threat, why hold back? But investors have already largely priced in future growth. The index trades at 24 times earnings, almost as expensive as the US market, and 40% higher than before the COVID crisis. There's also a large speculative position in the Nikkei by foreign hedge funds, which are unlikely to stay invested if volatility rises, as is likely this year. That argues for waiting for market turbulence to access better entry point. We would recommend to... wait for that moment to build up the investment in the region. Thank you for listening. And I look forward to seeing you very soon for another episode of Think Macro. If you enjoyed this episode, please subscribe and let us know your thoughts and any topics you'd like us to explore next.

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