The Latest Twists and Turns in Japan’s Economic Battle

Shinzo Abe

Since the election of Shinzo Abe as Prime Minister in 2012, Japan has instituted a number of bold economic reforms (dubbed “Abenomics”) to try to jolt the country’s economy back to health after almost a quarter-century of stagnation. These reforms included increased government spending, more purchases of government bonds by the country’s central bank, deregulation, and new international trade agreements. Recently, however, Abenomics has hit a bit of a snag.

In April Japan’s consumption tax rose from 5% to 8%, a change that was agreed to in 2012 before Abe was elected. The tax increase took the air out of the Japanese economy, which contracted in both the second and third quarters of this year. The tax was scheduled to further increase to 10% next year.

In response to the economic fragility, the government has changed tack. The Bank of Japan, the country’s central bank, introduced move aggressive stimulus efforts. Abe stated that he would delay the second phase of the tax hike. And he announced that he would dissolve Parliament and call a new election to try to solidify support for his economic agenda.

Will the new efforts succeed? One of the interesting aspects about Abenomics (and a lot of economic policymaking more generally) is its somewhat circular logic: its success largely depends on how confident people are that it will succeed. If businesses believe that Abenomics will boost the economy and end Japan’s persistent deflation, for example, they’ll be more willing to raise their employees’ wages, which will help boost the economy and end deflation.

Japanese stocks surged after the central bank announced its new stimulus plan, suggesting that many investors still have faith that Abenomics can succeed. But if Japan suffers another hiccup like the recent effects of the consumption tax increase, Abenomics might not be able to recover.

How Long Will Low Commodity Prices Last?

Commodity Returns

Commodities as an investment haven’t done well in recent years, but this year has been especially bad. They’ve been the worst-performing asset class in 2014, with a return of -16% year-to-date. Barring a rebound in the next month and a half, that would be their worst performance since the financial crisis in 2008. So is the pain now over for investors with exposure to commodities? The answer depends on the key factors that have driven down commodity prices.

Perhaps the most important factor affecting commodities is the pace of global economic growth. Stronger economic growth translates into more demand for commodities, but the global economy has slowed as growth in emerging markets declines and the European economy continues to stall. While the global economy grew by more than 5% per year in the mid-2000’s prior to the financial crisis, it’s only averaged around 3% growth per year since 2012.

The good news for those hoping for higher commodity prices is that the global growth rate may partially bounce back. The International Monetary Fund projects that the global growth rate will increase to around 4% per year over the next few years, powered by stronger growth in the United States and emerging markets. There are a number of ways that such a potential rebound could be thrown off-course, however, such as a sharp slowdown in the Chinese economy.

The outlook for commodities is also affected by factors affecting supply rather than just demand. In recent years these supply factors have particularly hurt the prices of energy commodities (such as oil and gas), which are largely responsible for the poor performance of commodities so far this year. Techniques such as hydraulic fracturing (or “fracking”) have led to increased energy production, especially in the US. Supply could increase further as technology continues to improve and makes energy production more profitable.

Over time, however, commodity prices have a self-correcting aspect: lower commodity prices themselves help reduce supply by making commodity production less profitable. This process doesn’t occur instantaneously, which is why commodity prices sometimes move up or down dramatically. But it does suggest that as commodity producers adapt to lower demand, prices are unlikely to keep falling for too much longer.

What the End of QE Will Mean

Fed Building

Many commentators have suggested that the good performance of both stocks and bonds in recent years has been largely due to the unconventional ways the Federal Reserve has tried to boost the economy. Chief among these has been its “quantitative easing” programs (or “QE”) that essentially use newly created money to buy bonds. With the Fed recently announcing the end of its third QE program, it’s tempting to think that markets may now be primed for a fall. The relationship between QE and investment performance, however, isn’t quite so simple.

It may seem obvious that stock prices rose because money from QE flowed through the financial system and into the stock market. But stocks also could have risen for other reasons, such as an improving economic outlook. The purpose of QE (and other Fed policies in recent years) was to boost the economy, and the economic growth rate has indeed increased: 4 of the last 5 quarters have been among the best since the financial crisis in terms of the GDP growth rate. It’s difficult to disentangle how much of the stock market performance was due to the side effects of QE rather than the improving state of the economy.

Similarly, it may seem obvious that bond yields have stayed low because the Fed has been buying bonds in its QE programs. But part of the reason the Fed initiated its QE programs was that economic growth and inflation were so low, which would also explain low bond yields. It’s even possible that QE led to higher bond yields as a result of the improved economic outlook, so the overall effect of QE on bonds is ambiguous.

Historical evidence leads to similar conclusions. The bull market survived the Fed ending its previous QE programs, and stocks have continued to rise since the Fed began winding down its current program almost a year ago.

Instead of focusing on the specific effects of QE, it may be more constructive to focus on the broader contours of the Fed’s policies. If it turns out that the Fed has pulled back its support of the economy too quickly, stocks are indeed likely to suffer. But if the Fed has correctly judged that the economy can continue to chug along, the bull market is may continue for a while longer.