The Bank of Japan takes action. Should you?
April 12, 2013
The Bank of Japan recently announced a slate of major monetary policy actions. We spoke with Charles Thomas, an investment analyst in Vanguard Investment Strategy Group, for insight on how these actions might affect the long-term outlook for Japan—and your portfolio.
What policy changes have occurred in Japan in recent weeks?
Following a string of policy developments over the past several months, the Bank of Japan, under the direction of the governor, Haruhiko Kuroda, has announced several aggressive policy actions, all designed to battle the persistent deflation that Japan has struggled with for more than a decade.
The bank plans to inject liquidity into the Japanese financial system by moving from an interest rate target that was effectively stuck at 0% to a monetary base target, or reserves that banks can use to increase lending. Its plan is to double the amount outstanding over two years.
The bank's aggressive measures are designed to move the Japanese economy out of the deflationary environment that it has been stuck in since the 1990s.
Any change in your portfolio's international asset allocation in response this announcement would likely be too late in the face of forward-looking markets.
Owning a mix of securities across all markets limits the impact of any single one while ensuring that you're exposed to the potential upside.
In addition, the bank will increase its purchases of Japanese government bonds across a range of maturities, to an annual pace of about ¥50 trillion, or about 10.5% of Japan's gross domestic product. The bank will also increase purchases of assets with higher levels of risk, including ETFs and Japanese REITs. It also announced several changes that should make bank operations more transparent and increase communication and forward guidance to the markets.
What was the market reaction to this announcement?
In terms of direction, the preliminary market reaction was very similar to other announcements of monetary easing by central banks. Equity markets reacted positively, Japanese government bond yields fell initially, and the yen weakened against the dollar and other currencies. The announcement exceeded investor expectations, so the immediate reaction was a bit more pronounced. But, overall, the reaction so far has reflected the market pricing in a favorable new outlook for growth and inflation.
How will these policy actions affect Japanese inflation and economic growth?
The aggressive measures undertaken by the Bank of Japan were designed to move the Japanese economy out of the deflationary environment that it has been stuck in since the 1990s. In the United States and Europe, policymakers have been working hard to prevent a similar environment from taking hold. Deflation is generally harmful to economic growth in that it causes consumers and businesses to hold back large purchases and investment plans. If prices are expected to fall, consumers expect that goods will be "on sale" in the future. This can lead to a vicious cycle of declining prices, falling wages, and stagnant growth.
Since expectations can act as a major driver of future inflation, the bank is taking bold action to try to "reset" the public's expectations for future inflation. The bank's announcement on April 4, along with its other recent measures, has already succeeded on this measure. The break-even inflation rate on 5-year, inflation-linked Japanese government bonds, a measure of the bond market's expected inflation, has increased to about 1.4%, from around 0.8% at the beginning of the year.
So we would expect breaking free of deflation to be good for growth, since modest amounts of inflation encourage households and firms to spend and invest today instead of holding back.
Should investors consider any immediate changes to their portfolios based on these actions? Where do you think an allocation to Japan fits in a long-term, balanced portfolio?
Because financial markets are forward-looking, market prices reflected this new, aggressive policy stance immediately. So any change in allocation in response to the Bank of Japan's announcement would be, in some sense, too late. That's why we don't advocate making changes based on short-term, headline-grabbing events like this. Staying the course remains a great strategy.
In terms of how we think about Japan in the context of a long-term portfolio, for most clients a good approach is to remain diversified and own a variety of securities across different regions and countries, including Japan. Within an international (excluding the United States) equity allocation, a weighting in line with market capitalization would be a very reasonable starting point for most investors. The same is true for an international fixed income allocation, with the caveat that currency risk becomes a significant factor for fixed income investors and needs to be hedged.
Turning to elsewhere in Asia, what's the risk that instability in North Korea will affect the South Korean economy? At what point might investors consider taking steps to hedge against these risks?
It's a very uncertain situation in North Korea, given the radical nature of the regime, so it's difficult to say what the outcome will be. And this is precisely why we recommend a diversified approach to investing.
Owning a mix of securities across all markets limits the downside impact of any single one while ensuring that you're exposed to the potential upside. So in situations like this, where the outcome is unknown, the best reaction is to focus on the things you can control: Make sure you have a solid long-term investment plan, stick to your asset allocation, stay broadly diversified, and keep costs down.
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