The Days Ahead:

  • Jobs report.

This Week:

  • Japanese stocks break the 34-year old all-time high.
  • We look back at 1989 and forward to the changes underway.
  • The market is up 42% in the last year but still a happy hunting ground for value investors.
  • Germany made three big strategic mistakes over the last decade.
  • It’s paying for them now.
  • Inflation is doing what the Fed wants.

It Was 34 Years Ago Today…

Well, not quite but December 1989 marked the peak of the Japanese stock, property and everything boom.  Since then, the economy has suffered decades of deflation, a shrinking population and numerous false dawn stock market rallies. Finally, last week, the Nikkei 225 Index of Japanese stocks closed above the 1989 peak.

They say, “Stocks for the Long-Run” and we’d agree. But you also need well managed companies, a spirit of innovation and entrepreneurialism, strong incentives and governance and a dynamic work force. The U.S. has all those in abundance. Japan did not. If you were 30-years old when the Japanese stock market peaked, you’re now at retirement age and missed a lifetime of gains.

Two generations of Japanese investors only invested in low-paying government bonds and life insurance. Deflation helped Japanese retirees. Prices are only 10% above what they were in 1989 and 6% of the increase was in the last two years. There was a period from 1994 to 2020 when prices were flat or down every year. If prices fall and wages stay flat, there is a form of savings going on. But it’s highly inefficient.

How big was 1989? Very. All four people in our 1989 headline grab below were household names in the U.S. One, Akio Morita, the founder of Sony, regularly appeared in American Express commercials. The Drayton Asia Trust was an off-the-page investment fund that raised $500 million in one day. No prospectus. Just send a check. It was heavily oversubscribed.

It was also the time when Sony bought Columbia Pictures, the value of the Japanese stock market was 37% of all global stock markets, and Tokyo’s Imperial Palace, a 280-acre park with nice views but limited commercial scope, was worth more than all California real estate.

The Industrial Bank of Japan (IBJ), was then the world’s most valuable company at $104 billion. Citibank was worth around $2 billion. Eight out of world’s top 11 most valuable companies were Japanese. Today only one, Toyota at 29, is in the 100 largest global companies.

An early, and not great, Picasso sold to a Japanese real estate developer for $51 million. It would be another 20 years before another, better Picasso sold for as much. IBJ no longer exists

It was that kind of bubble. Everything, all at once and then a slow, grinding, multi-year 80% correction. It’s taken 12,400 days to recover from the 1989 highs. That dwarfs the recovery of the Dow Jones Index from the 1929 crash which took 9,194 days to recover its peak.

Fast forward to today, and the recovery is down to three reasons, often dubbed the “Three Arrows of Abenomics”, named after the late Prime Minister Shinzo Abe.

The first was aggressive monetary policy. The Bank of Japan (BOJ) drove interest rates down to below zero and bought 54% of all Japanese Government bonds. The Fed peaked at around 24% in 2022. The BOJ also bought stocks, ETFs, corporate bonds, and real estate commercial paper for good measure.

The second was “flexible” fiscal policy, which, “not to put too fine a point to it”, failed. There was plenty of infrastructure spending and short-term demand policies, but debt to GDP grew from 40% to 226%.

The third was “structural reform,” which was not one arrow but dozens of smaller projectiles intended to free up regulations and introduce financial and business reforms.

The third arrow is most responsible for the market rally. The government encouraged companies to start share buybacks, release excess cash and unwind cross holdings. In 2023, the Tokyo Stock Exchange put more heat under companies that traded at prices below book value, failed to deliver clear growth strategies or could not articulate plans to increase returns on capital. It was a “name and shame” strategy and it worked.

Management took things seriously. The Nikkei 225 rose 30% in 2023 and is up 17% year to date. The demon of the 1989 peak of 38,271 was breached on February 26, 2024. There’s a natural exuberance that the level from a generation ago is finally beaten.

Will it last? Yes. Here’s why.

One, corporate governance reform has just started. There are now 150 non-Japanese board members on Tokyo-listed companies, up from 20 less than 10 years ago.

Two, Japan may increase global mergers. Nippon Steel’s bid for U.S. Steel is big, at $15 billion, and very public. It should satisfy trade commissioners especially as it involves no job losses.

Three, Japan’s fight against deflation is working. We’ll know more when the annual “Shunto” wage negotiations kick off in a few weeks but the average increase should be around 5%.

Four, rising defense spending. Japan has long held a strictly neutral stance on defense but with three aggressive world powers on its borders, it’s rethinking spending. Russia is 25 miles away, North Korea 180 miles and China 500 miles, with lots of disputed territory in between. North Korea has a habit of lobbing missiles over Japan’s airspace, especially in election years.

Five, Japan is a happy hunting ground for value investors. Stocks remain cheap and pay decent dividends. There are no equivalent high flyers like the Mag 7 but there are plenty of companies expected to do well. The market also has decent breadth. The top 10 companies account for 13% of the index compared to over 30% for the S&P 500.

We expect a pause before further rises. The BOJ will hold its second meeting of the year in three weeks and will want to see evidence of higher inflation before it raises rates. But outlook for Japan looks solid. And a heck of a lot better than the last 34 years.

Calling Germany

There’s a new investment acronym in town. It’s GRANOLAS and Europe’s answer to the Mag 7. It stands for Glaxo Smith Klein, Roche, ASML, Novartis, Novo Nordisk, Nestlé, L’Oreal, LVMH, Astra Zeneca, SAP and Sanofi. Ok, it’s liberal with the names but GRANOLAS sounds better than GRANNLLASS. They’ve outperformed the Mag 7 over the last two years.

But there’s only one German company.

Germany is the largest economy in Europe, 40% larger than France and with a 30% bigger population. It recently surpassed Japan as the world’s third largest economy but that is entirely because of the weak yen. If the yen appreciated to its 2021 level, Japan’s economy would be 40% larger than Germany’s.

Either way, you’d expect robust growth in Germany. But no. This is what real and nominal GDP have done in the last 20 years.

Real GDP is up 29% and nominal GDP up 93%. Over the same time U.S. GDP was up 48% and 134%.

Germany’s story goes back a while. The economic strategy for most of the last 25 years was more Russia, more USA and more China. All three backfired.

More Russia was about importing natural gas from Russia. Germany’s gas imports grew from €4.2 billion in 1994 to €67 billion in 2022. Cheap gas and a 45-year old “no nuclear” movement meant the government phased out nuclear energy since 2011. The last nuclear plant was switched off in 2023.

Russian gas was pumped via Nord Stream 1, which went under the Baltic, and through pipelines in Poland and Belarus. Gas lines through Ukraine were deemed politically risky and never implemented. Piped gas is cheaper than liquefied natural gas (LNG), which must be pressurized, liquified and chilled at the starting depot and reversed at the end depot. Germany had no LNG terminals in 2020. It now has three floating terminals.

Germany doubled down on Russian gas for 20 years. When Russia invaded Ukraine in February 2022, the strategy lay in tatters. It’s in the process of redirecting its energy supplies from Norway, the Netherlands and the U.S.  

Meanwhile, German industry, which is around 27% of GDP, compared to the U.S. at 18%, used natural gas as a feedstock for its chemical, metals and auto sectors.

The Russia strategy unwound quickly. There are new supplies on the way. But they’re expensive and logistically complicated.

The More China strategy involves exporting goods to and building plants in China. The graph shows Germany’s foreign direct investments (FDI) in the last 10 years. In Germany’s case, it meant setting up factories and subsidiaries in other countries.

Over the last 10 years, Germany invested a total of €1,340 billion in overseas plants, including $400 billion of direct investment in the U.S. and $120 billion in China. There are over 5,000 German companies operating in China with one million employees. German auto manufacturers have 350 locations in China selling 4.0 million cars in 2023 down from 5.1 million in 2019. Germany also builds around 840,000 cars in the U.S. some of which are exported to China.

That seems good. German companies in China selling to China and German companies in U.S. selling to the U.S. and China. China was Germany’s largest trading partner. Germany was leading in both FDI and trade. What could go wrong?


China launched the “Made in China 2025” program in 2015 and, as its title suggests, planned to make more of its own high-end products for domestic and export markets. China now leads the world in electric vehicles (EV). German companies trail far behind in EV technology. China is pouring state subsidies into aerospace engineering, robotics, solar, electrical equipment and high-end rail and maritime infrastructure – all industries that Germany dominated for years. Finally, as China slowed, so did Germany’s trade with China.

The chart shows German exports to China (in blue) back to the level of five years ago. Imports from Russia (in green) collapsed following EU sanctions on Russia.

The More America strategy was to build direct investments and rely on U.S. protection. German defense spending dropped to less than 1.2% of GDP from 2000 to 2019. In constant prices, defense spending is 17% below 1990 levels. That should now change with the defense budget planned to rise to €100 billion in the next few years from €55 billion in 2022.

Put all this together, and it’s clear Germany must tread a delicate path with China. It has direct investment and trade which China is openly challenging. It must reengineer its energy policy. It must build out defense and security capabilities after years of neglect. It must deal with new politics. The three main parties have seen their popularity slump from 57% of the vote two years ago to 32% now. The AfD far-right party rose from 9% to 22%. And it must deal with strikes in the agricultural and transport sectors as it tries to cut subsidies.

That’s a lot to do. Last year, German GDP rose just 0.3% and was the worst-performing major economy. In the last two quarters of 2023, GDP fell, technically putting the country into recession.

For now, Germany is stuck. The economy will be flat in 2024 and lag the rest of Europe. It’s unlikely to deliver much to the Granola success stories.

The Bottom Line

News this week continues to push the likelihood of rate cuts and recession ever further down the road. The Fed’s favorite measure of inflation rose more than expected for the month but at 2.8% remains on target for the year. Wages and salaries rose 0.3%, well within the Fed’s comfort zone. As usual for the last year, goods prices were down and services up.  

GDP was revised down slightly for Q4 2023 but  that’s rear-view mirror news. Fed speakers were out in force, banging the drum on the need to move slowly. The Fed is doing all it can to dampen market expectations of a cut prior to June. There are few distant calls for rate hikes but we don’t buy it.

Stocks took a break from ongoing gains this week but they’re up 3.2% for the month and 6.6% since January. Both Europe and Japan continue their march upward.

The 10-year Treasury remains in the 4.2% to 4.3% range. It will take a big disappointment in inflation or a blowout jobs number next week to move it meaningfully either way.

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Art of the Week: Kylie Manning (b. 1983)

Please read important disclosures here.