Market Views

Joe Zidle: Japan’s Past is Europe’s Prologue

Like those of Japan, the Eurozone’s issues are permanent and secular ⁠— and worthy of a similar policy response.


In The Tempest, Antonio utters one of Shakespeare’s most enduring lines, “What’s past is prologue.” Antonio uses the phrase to describe (and rationalize) how the past set the stage for what he and his cohort Sebastian are about to do. Spoiler: It’s something really bad. In his penultimate meeting as European Central Bank (ECB) chair in September, Mario Draghi may have concluded that Japan’s past can show Europe the way forward. Europe’s troubles today resemble the challenges Japan has dealt with since the late 1980s: demographics, debt and deflation. It’s no coincidence that the ECB’s new open-ended liquidity and negative rates rhyme with the policies that Japan began exploring in the late 1990s. It all may seem bleak for Europe’s economies, but its companies can find solace in Japan’s policy path.

“Japanification” of Europe under way. The ECB’s decision to restart quantitative easing (QE) might seem like a temporary mechanism to combat a short-term slowdown caused by trade. But like Japan, the eurozone’s issues are permanent and secular. Even if trade tensions were resolved in the short term — an assumption we are not comfortable making, given global shifts away from globalization and towards regionalism — Europe’s woes would not disappear. We’re considering the possibility that, as in Japan, open-ended QE and zero or negative rates in Europe are here to stay.

ECB faces the law of diminishing returns. Studies show that quantitative easing’s effectiveness may be decreasing.(1) The ECB grew its balance sheet from €2 trillion in 2014 to nearly €4.7 trillion this year, but the European Union’s GDP grew by just €410 billion over the same period.(2) This implies that each incremental euro of stimulus produced just €0.16 of economic growth. Similarly, the Bank of Japan has added 392 trillion yen to its balance sheet since announcing its first round of massive QE in April 2013. Over the same period, the Japanese economy grew by 56.6 trillion yen, or 0.14 yen of growth for every yen of balance sheet expansion.(3) Such meager growth helps explain why Draghi dialed up his pleas to fiscal policymakers in the September ECB meeting. The EU economy needs more support than deeper negative rates and balance sheet expansion can provide.

Perhaps this is a problem that can’t be solved with money. A critical difference between Europe and Japan is the latter’s willingness to coordinate fiscal and monetary policy. Germany, the Eurozone’s largest economy, historically avoids deficit spending, in part due to longstanding inflation fears. But projections peg Eurozone inflation near 1% in 2019 and 2020.(4) Also, Germany’s 2Q’19 real GDP growth was negative year over year, and a full-on recession is a real possibility this year. With the current combination of monetary stimulus, low inflation, slowing growth and fiscal space, Germany may be amenable to fiscal stimulus across the EU. But Japan’s experience argues the slow growth problem won’t be solved with more money alone.

Fortunately, companies aren’t the economy. Recession risks will remain ever-present in Europe over the long term. But in the short term, easy liquidity means that fewer adverse credit events are likely to occur, and that spreads may tighten slightly with lower credit risk. As a result, differences in corporate survival rates among eurozone countries will likely narrow. In the EU, Belgium has one of the best ratios between a one-year and five-year company survival rate.(5) Fiscally conservative Germany is more cutthroat, with one of the worst.

Japan’s experience is again instructive; corporate bankruptcies are rare.

Japan vs. US Corporate Bankruptcies and Recessions (6)

10Y/2Y Spread Inverted Before Each of the Last Five Recessionss

As the chart above illustrates, the number of bankruptcies in Japan is structurally low relative to the US. While the US has only 39% more business establishments than Japan does, it has more than three times as many bankruptcies.(7) The Japanification of Europe might mean that growth will flatline in the foreseeable future — but European companies are likely to stay on life support.

1. World Bank, Ayhan Kose, Various Authors and DB Global Research. Represents the average of academic studies on the impact of QE on long-term interest rates.

2. European Central Bank and Eurostat. Represents change in ECB assets and euro area gross domestic product over the period 7/1/2014 through 6/30/2019.

3. Bank of Japan and JP. Cabinet Office. Represents change in BoJ assets and Japan’s gross domestic product over the period 4/1/2013 through 3/31/2019.

4. Bloomberg composite of economic forecasts, as of 10/10/19.

5. Eurostat, as of 2016. Based on the one- and five-year survival rates of enterprises, business economy. Analysis includes EU-28 countries plus Iceland, Norway and Switzerland.

6. Thomson Reuters Eikon, Teikoku Databank, and Administrative Office of the United States Court. Bankruptcies for each respective country based on trailing twelve-month bankruptcy filing volumes on a quarterly basis, as of 12/31/18. Recessions represent periods with at least two quarters of consecutive negative real GDP growth on a year-over-year basis.

7. Japan Ministry of Economy, Trade and Industry and US Census Bureau. Based on 5.58M establishments as reported by Japan’s 2016 Economic Census for Business Activity, and 7.75M establishments as reported by the US Census’ 2016 Statistics of US Businesses (SUSB) data series.

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