Must-know: What will support Japan’s wealth effect and auto sales?

Market Realist

For GM, which is worse—the recall or a weakening yen? (Part 8 of 12)

(Continued from Part 7)

Japan’s wealth effect—improving but a long way to go

The below graph reflects the ongoing decline in the rate at which residential investments had been made in Japan, as well as a modest recovery post-2010. As with other forms of fixed investment noted earlier in this series, Japan has seen a long-term decline in the housing market since the peak of the economic bubble, which was accompanied by a real estate bubble, much like the one the U.S. experienced until 2008. As in the U.S., the rising value of housing supports consumption data. When housing prices rise quickly, consumers spend more money on everything—including longer-term expenditures such as autos. This article discusses the prospects for residential investment growth recovering, as a result of changes in Japan’s economic policies, and the impact it can have on consumption in Japan.

For more detailed analysis of the overall Japanese economy, read Bank of Japan Tankan supports a 2014 equity rally in Japan.

Historical oversupply

The decline in residential investment in Japan has been driven by the overbuilding during the housing bubble of the 1980’s into the early 1990’s. Plus, Japan’s population has also remained largely unchanged since 1995, while the U.S. population has grown approximately 18% since 1995. Clearly, Japan’s ageing society demographics and flat real GDP growth would suggest that Japan has little need for incremental growth in the number of housing structures, outside of replacement-related building.

Why let that stop the building?

Bloomberg recently reported that there is evidence of a Japan-style housing bubble developing once again. In an effort to spur the Japanese economy, Japan’s new Prime Minister, Shinzo Abe, has pushed for reforms to encourage the construction industry. As noted in the above graph, Japanese residential investment has been on a notable upswing, or at least a modest bounce, since 2011. With Abe in office, it is possible that this trend can continue. Should Abe achieve his 2% inflation target, and slay Japan’s deflationary demons, it is conceivable that housing prices might even firm up, and reinforce additional new construction.

The 1.8% mortgage and creative destruction

Many Japanese lament this development as it is estimated that there will soon be nearly 20% of Japan’s housing stock left in abandonment. This sounds like Japan is on its way to becoming the world’s biggest Detroit, although things are a little different in Japan (aren’t they always?). It is likely that a large number of the housing units left in abandonment in Japan tend to be very cheaply constructed units, whose reasonable utility is somewhat out of step with modern standards. The U.S. houses are built to last closer to 100 years, whereas in Japan, the shelf life of residential construction is estimated to be closer to 38 years.

As a result, Japanese landlords renting old, shabby, 1980’s construction style units are understandably upset that the younger generation does not wish to rent the old units, which may not even have central heating and air. The old fashioned tatami flooring does not age well, and the modern, urban Japanese citizen tends to demonstrate a strong preference to modern, Western-style dwellings. This has been great news for Japan’s major home builders such as Daiwa House and Sekisui House.

As the above graph suggests, these home builders were in terrible need of new orders, and the vested interests of slumlords was likely a significant hurdle in a much desired urban renovation of housing stock. Perhaps Abenomics will be accompanied by the broom of creative destruction, although changing the rules against Japan’s vested interest has remained a major challenge in achieving any real form of “structural reform” in Japan since 1990. Perhaps this is a step in the right direction. The current 35-year mortgage rate of 1.8% certainly seems to have attracted some new buyers.

Japan’s equity outlook

As 2014 progresses, investors may see a continued outperformance of Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan ETF (EWJ) versus China’s iShares FTSE China 25 Index Fund (FXI) and Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further clarification as to why DXJ may outperform both EWJ and the other Asian equity indices, read Why Japanese ETF’s outperform Chinese and Korean ETF’s on Abenomics. Plus, as Japan pursues unprecedented monetary expansion, and the U.S. Fed tapers its bond purchases, Japanese equities can also outperform broad U.S. equity indices, as reflected in the State Street Global Advisors S&P 500 SPDR (SPY), State Street Global Advisors Dow Jones Index SPDR (DIA), and Blackrock iShares S&P 500 Index (IVV).

Continue to Part 9

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