Many times, the disruptions that prove most damaging to markets are the ones that are least expected. The collapse of Long Term Capital Management in 1998, for example, was an event that came out of nowhere and triggered a 20% slide in the S&P 500 over a two-month period.
We have been discussing at length the risks associated with unrest in the Middle East, higher energy prices, slowing earnings and gross domestic product (GDP) growth, and rising inflation. But we think the potential for higher-than-expected interest rates in Japan could represent one of the greatest long-term risks facing the global capital markets.
Japan has finally emerged from the doldrums it entered in 1990, when its overheated real estate market collapsed. We believe much of Japan's recovery can be attributed to Prime Minister Koizumi's free-market reforms. After expanding 2.7% in 2005, Japan's economy should generate 3.2% real GDP growth in 2006, according to research firm Global Insight. This would mark the third consecutive year of expansion in excess of 2%. With deflation finally at an end, the Bank of Japan (BOJ) bid its longstanding zero interest rate policy goodbye by raising short-term rates to 0.25% on July 14. Long-term rates are about 1.85%. Annual Japanese consumer price index growth remains less than 1%, but with unemployment at 4.2%, wages on the rise, and consumption growing, the stage is being set for potentially significant increases in prices over the next couple of years.
In Japan, short- and long-term interest rates have been extremely low for a number of years. As a result, Japanese investors have exported their savings overseas in search of higher yields. U.S. Treasuries have been the prime beneficiaries, as Japanese investors have funded robust U.S. consumption through the large-scale purchase of U.S. government debt. But rising inflation in Japan could lead to increasingly competitive Japanese rates, possibly fueling the widespread repatriation of Japanese assets. Given Japan's consistent status as a leading global saver, any meaningful reduction in this critical source of funding could exacerbate growing worldwide fiscal and trade imbalances.
With U.S. consumption currently funded largely through the sale of Treasuries to Asian central banks like the BOJ, any significant decline in Japan's appetite for U.S. debt could lead to a spike in U.S. interest rates and a decline in the value of the dollar. This would undoubtedly lead to slowing U.S. economic growth, as consumers scaled back and the housing market cooled further. In addition, the U.S. equity risk premium would likely rise, as p-e ratios fell in response to higher interest rates. Investors tend to shun stocks as rates rise because the higher cost of capital is a negative for corporate earnings and because higher yields make bonds more attractive.
The BOJ's rate hikes reflect Japan's strong economic growth, low unemployment, and increased pricing -- all good for corporate earnings and stocks. But over the longer term, if accelerating inflation requires significant additional rate increases, fears of a profit slowdown would mount and likely hurt Japanese equity valuations.
This scenario is, of course, far from imminent. Japanese interest rates are still low on an absolute basis. But S&P Equity Strategy believes the grave consequences of such a scenario warrant close monitoring of Japanese inflation and interest rate trends.
S&P's Model ETF Asset Allocation Portfolio, based on our Investment Policy Committee's recommended asset allocation, has a 5.5% weighting in Japan: 2% from iShares Japan (EWJ) and an additional 3.5% through iShares EAFE (EFA). Our allocation to U.S. equities is 45%, with 35% large-cap (SPY), 6% mid-cap (MDY), and 4% small-cap (IJR).