You better Ueda Minute

April 04, 2024

"Japan's economy is recovering moderately, although weakness has been seen in some data," BOJ Governor Kazuo Ueda

Japan has seen something of an economic renaissance over the past year. In 2023 the Japanese equivalent of the S&P 500 (i.e., the Nikkei 225) rose 30% and hit a 34-year high at the beginning of this year. GDP grew at over 2% in the first half of the 2023, and inflation (incorrectly viewed as an indication of economic growth) rose to over 3% in the middle of last year – a pace not seen since 1981!

This was a welcome sign for an economy that has struggled with an aging population and a lack of productivity growth for decades. It suggested to many analysts that the Japanese central bank might finally – after 8 years – begin to raise the Bank of Japan’s short-term rate target out of negative territory. It did just that last week, raising their benchmark rate for the first time in over 15 years. This is the expected response to a growing and inflationary global economy, which many analysts continue to see as the most likely scenario for 2024.

Despite those expectations, however, BOJ Governor Kazuo Ueda (pronounced “wait uh”) knows that Japan has been here before, and that those inflationary expectations always were dashed to pieces on the disinflationary rocks of an over-indebted and aging Japanese economy. Recent data, which has implications for the US as well, are delivering a message to the BOJ that states loud and clear, “you better “Ueda” minute.”

Marvelletes Disinflation

Back in 1961, the Marvelletes released a song called “Please, Mr. Postman”. It was a teenybopper song about a girl waiting for a letter from her boyfriend, which reached number one on the Billboard Hot 100 singles chart later that year. That song was covered many times – including by the Beatles – and eventually hit number one again in 1975 when The Carpenters re-released it. It’s a tune that, like debt and demographic driven disinflation in Japan, just won’t go away.

Over the past 12-18 months, much of the global economy has ridden the back of so-called “immaculate disinflation”. This term refers to a supposedly good environment where inflation falls while the economy continues to grow. At least one popular measure of economic growth (i.e., GDP) has remained robust in some parts of the world while inflation has steadily fallen. These developments have some economists claiming the economy is strong and there is no danger or recession in sight.

Japan’s Nikkei 225 just recently reached an all-time high. So did the stock markets in Germany and the US. Official labor market indicators continue to imply that there are plenty of jobs available, and artificial intelligence is supposedly going to usher in a new era of productivity growth. Marvelous disinflation is thus welcomed as a sign that central banks around the world are winning the battle against inflation while avoiding any sort of negative economic consequences.

Mr. Postman, Look and See

But what if this marvelous disinflation is like watching a beautiful sunset from on top of an erupting volcano? We may just wish the Postman had passed us by.

Currently, the Nikkei 225 is at an all-time high. Yet, Japanese GDP has contracted over the past two quarters, plunging the world’s third (no wait, fourth) largest economy into recession. Meanwhile, Germany’s flagship stock index (i.e., DAX 40) recently hit an all-time high as well. And yet, German GDP has also contracted for two quarters in a row, putting the world’s fourth (no wait, third) largest economy in a recession as well.

Beyond this, Japan’s recent inflation data is sobering with the 3-month rate coming in at a minus 0.7% annualized. Germany’s is about the same. And China – the perpetual growth engine of the global economy over the past several decades – is also suffering from deflation on a year over year basis and weak GDP growth that most consider to be recessionary.

On second thought, perhaps we don’t want the mail delivered so quickly.

A Letter In Your Bag?

There are so many lettered acronyms that get thrown around finance, it’s like consuming an alphabet soup from a fire hose. GDP (a measure of economic growth) and CPI (a measure of inflation) are probably the most prominent. And in support of the growth narrative, many pundits point to recent CPI and GDP data. And on the surface, they paint a picture of a healthy US economy.

However, there are several problems with these positive economic numbers. The BLS’s official inflation metric is a severely lagging indicator, incorporating components that are no longer relevant. The Fed’s preferred metric is already close to their target 2.4% over the past six months. Stripping out the grossly outdated shelter component, a more accurate reading of official CPI is likely already running below 2%. And some alternative measures of inflation have been showing around 2% inflation for several months now.

But what about GDP? The past two quarters have seen GDP growth at an annualized rate of over 4%, which is faster growth than the US experienced for much of the past 15 years. Even here, though, there are reasons to doubt the usefulness of the data. First, much of the GDP growth in 2023 came from government spending. While US GDP grew by $1.5T, US government debt grew by almost twice as much (i.e., $2.6T). With government spending outpacing economic growth by a ratio of almost 2-1, the US is beginning to resemble an unproductive third-world country rather than a bastion of free-market enterprise.

Confirmation of this problematic trend can be found in comparing GDP with the less popular Gross Output (GO). It’s a sign of our times that GO is relatively unknown. It is actually a much more useful measure of economic growth because it measures all business activity in the economy, not just final spending (like GDP). As a result, both government spending and consumer spending play a smaller role in changes in GO. When GO grows at a slower pace than GDP, it’s a strong indication that the economy is weakening, and recession risks are climbing. Over the past year, that is exactly what’s been occurring.

In addition, GDP has historically grown alongside another macroeconomic indicator: Gross Domestic Income (GDI). However, over the past 12-18 months, GDP has been increasingly deviating from GDI, indicating some unusual oddities in the data. Interestingly, GO and GDI have been closely correlated recently, thus calling into question official GDP.


This divergence is significant over longer periods of time as well, suggesting that GDP may in fact be much lower than is currently estimated. If GDP were to be revised lower in the future (which occurs frequently) to comport with GDI and GO, current real (adjusted for inflation) GDP would be negative on a year-over-year basis, indicating the US is either close to or alreadyin a recession. But even if downward revisions were not to occur, the narrative of a strong economy based on GDP is questionable at best.



A Tear In My Eye

The news of recent all-time highs in the major stock indices in Japan, Germany, and the US also need to be carefully considered against a bleak economic backdrop. It is highly unlikely that recessions in the third (Japan), fourth (Germany), and sixth (United Kingdom) largest economies, as well as recessionary conditions and deflation in the second largest economy (China) will not have spill-over effects on the US at some point.

In a twist of financial irony, it is quite possible that US stocks and the US financial system have been the short-run beneficiaries of economic pain currently being felt all over the world. In times of economic stress, investors look for safer assets. And when emerging and developed economies are feeling the strains of slow growth or contraction, capital (and people) will tend to flow to “safer” economic environments. This may be one reason why, despite the US government’s financial irresponsibility, the US dollar continues to strengthen compared to its major competitors.



A Mighty Long Time

And a peak under the hood of these so-called strong equity indices also suggests some concerning trends. For instance, the Nikkei’s recent all-time high in Japan was last seen when I was just growing out of diapers (or when communism was failing…depending on your timeline markers). Can you imagine being a 99-year-old Japanese citizen today? You’re waking up to the news that you finally have a positive return on the stocks you bought when you retired at 65? Yeah, I see the tears standin’ in your eye.

Further, the continuing deterioration in the Chinese economic backdrop may account for much of the Nikkei’s recent rise. As investors have become increasingly concerned about China’s political and economic health, they have chosen to move their capital to a relatively close (but safer) environment – Japan. Below is a graph of China’s main Hong Kong index overlapped with Japan’s Nikkei 225. After China re-opened (post-covid lockdowns) last year, the hoped-for economic recovery began to underwhelm. As the economy continued struggling, the main stock index saw massive declines at the exact same time Japan’s stock market began seeing inflows. I suppose it could be a coincidence, but it certainly jives with a lot of other data we’re seeing.


Some of that other data is found in America, as stock indices in the US are increasingly detached from the economic realities they supposedly reflect. The S&P 500, for instance, is the most heavily concentrated it’s been in the last century.


The above chart is an indicator which has almost always been associated with one of two possibilities. The first is a market top, as greed takes over and investors pile into the “best” companies (e.g., 1939, 1973, 2000, 2020). The second is market bottoms, as fear takes over and investors pile into stocks they perceive to be the safest (e.g., 1932, 2009). But with the S&P 500 at all-time highs only 7 stocks out of 500 in the S&P 500 index making up almost 30% of the market capitalization, this concentration appears to be more about greed than fear.


In fact, the seven largest stocks in the US in terms of market cap are considered more valuable than any other economy’s stock market in the world.


Perhaps the most damning indication of the weakness and frailty of this latest stock index rally is that vast portions of the stock market are still down over the past two years. The Russell 2000, which is made up of smaller companies, is still 16% below its top in 2021. And over three-quarters of the stocks in the Russell 3000 (a broad market index) are still in a bear market!

This is certainly not your grandfather’s bull market.

So-o, So Patiently

No doubt Japan is in quite the predicament. The economy is clearly struggling along with many others around the world. Despite being on the verge of yet another recession, however, the BOJ is under immense political and economic pressure to hike their short-term rate as the stock market continues rising and inflation remains above (albeit barely) its long term target.

But the BOJ is only one Central Bank among many that are in a similar situation. The ECB is already nodding towards future rate cuts but is afraid as the Eurozone is teetering on recession and deflation. The Fed, likewise, continues to claim the economy is strong while also forecasting 7 rate cuts in the next 21 months. And central banks around the world are already cutting rates at a pace not seen since the depth of the covid shutdowns in June of 2020…to be overshadowed only by the depths of the Great Financial Crisis in 2008-09.


But to understand central banks really boils down to the fact that all of them fear one thing more than any other: receiving the blame for inaction. The irony is that, like the Marvelletes anticipating a letter from their boyfriend, the waiting is hardest part (or is that Tom Petty?). In a similar fashion, central banks have no idea whether to hike or to cut. But what they do know is that if they do nothing, they will almost certainly get blamed for a bad outcome.

Unlike central banks, though, individual investors need not fret about “missing out” on the all-time highs in stocks. The progressively problematic economic backdrop should be weighed against the impulse to jump into these increasingly concentrated casinos we call “stock markets”. And if that’s your inclination, all I can say is: you had better Ueda minute.