Hypothermia in the land of the rising Sanae

Hypothermia has strange effects. When rescuers reached Lincoln Hall, an Australian mountaineer who had spent a night out above 8,000 meters on Everest in temperatures of minus 30 degrees Celsius, he was trying to remove his jacket. Extreme cold can leave victims feeling hot.

That example is offered from the Chinese economist Li Xunlei, who is fascinated by the tendency of those suffering from severe hypothermia to take off their clothes. There is an analogy:

I am not a medical specialist, but I wonder: When an economy "cools into hypothermia,” can markets also experience an illusion of warmth? And how destabilizing might such false signals be for the economy?

The case he has in mind is Japan — although like many in China, he’s also concerned that his own country may be feeling hot when it is in fact freezing. For more than three decades, Japan suffered through an economic Ice Age as inflation, growth and interest rates stayed stuck while the population shrank. In constant currency terms, Li points out, gross domestic product per capita sank from $38,467 in 1994 to $25,824 — despite the fall in population. The U.S. doubled to $57,000 from $28,000 over the same period.

Of late, the country has suddenly given every impression of heat. There are at least three good reasons to believe hypothermia is over:

Inflation is back. Official core inflation, excluding the price of fresh food, stands at 2.7% and has exceeded the widespread target of 2% for three years. Bonds are now priced on the assumption that Japan’s inflation will equal that of the U.S. over the next five years.

Markets are back. Local stock indexes have finally topped the record they set at the height of the bubble in 1989 and are surging forward.

Politicians from the long-governing Liberal Democratic Party chose Sanae Takaichi to be the nation’s putative first female premier. An aggressive and charismatic leader touted as the Japanese Margaret Thatcher, of whom she’s a big fan, she represents a startling turn from Japan’s consensus politics.

The difficulty of making political change remains strong. Takaichi’s attempt to break that consensus has already run into serious trouble. The LDP’s junior coalition partner, Komeito, has withdrawn support and a week of political maneuvers lies ahead.Whatever Takaichi’s success in piecing together a new coalition, the opportunity presented by an economy at last springing into life appears immense. But is this a hypothermic trick of the senses? Japan wouldn’t be the only country where the pandemic broke decades of stasis and warmth might indeed be spreading through its veins again. But there are reasons to question whether apparent cracks in the ice reflect anything more than desperation.

Inflation

The numbers seem clear. Inflation stayed below 1% for three decades, interrupted only when new consumption taxes would briefly jolt it higher. Since the spring of 2022, it has never dropped below 2%. Alone among central banks, Japan’s has made it an aim to raise inflation rather than reduce it, and looks to have succeeded.

This might seem a crazy aim, but persistent very low inflation can be both symptom and cause of serious economic weakness. It suggests there isn’t the necessary demand and activity to drive prices higher, while consumers who expect prices to stay stable or fall are far more likely to defer purchases than people living with inflation, putting the economy into deeper sleep.

Wages are also picking up — another crucial sign of returning life. Traditionally, wages throughout the economy are driven by the annual shunto negotiations between unions and the biggest companies. From 1999 to 2022, the shunto round never yielded a raise of more than 2.2%. In the last two years, workers got more than 5%.

But it’s not that clear the ice has decisively broken. Wage rises have now declined for eight months. In nominal terms, they were up only 1.5% in the year to August — and down 1.4% in real cash terms. Beyond that, much of the inflation resurgence is definitional. If "core” excludes all food and energy as it does elsewhere, and not just fresh food, then it’s running at 1.6% — below target and still far lower than everyone else. The big increase in the official core has been driven by a bad rice harvest that led to very unpopular rises in the price of Japan’s staple.

This wage malaise isn’t new and is hardly surprising given this year’s shocks to the economy, says Stefan Angrick of Moody’s Analytics in Tokyo: "U.S. tariffs and tariff threats have damaged manufacturing, created uncertainty and delayed investment in capital and workers. But it’s striking that underlying wage growth hasn’t proven more resilient.”

Finally, inflation is in many ways a quirk of the dramatic weakening of the yen. The currency took a big step down in 2022 as all other major economies started to hike rates aggressively. The yen started 2021 at ¥103 to the dollar, which is about fair value. It’s now at ¥153. Japan is a heavy importer, and this feeds directly into inflation — but it’s not clear that price rises would persist if the yen strengthened.

This leads to a horrible problem. Takaichi said last year that the Bank of Japan would be "stupid” to hike rates, and it’s obvious many at the bank agree. Tighter money might strangle whatever growth the economy is managing to generate.

Markets

The argument that markets have beaten hypothermia appears stronger. The Nikkei 225 set a record of 38,915 on New Year’s Eve 1989 that was to stand for 33 years. Since finally breaking above that in late 2023, the Nikkei has surged on. The rally after Takaichi won the party leadership last weekend brought it above 48,500 — and it remained above 48,000 after news of the coalition collapse broke Friday. Valuations are their highest since the start of 2008, with the companies on the Topix now trading at 68% above book value.

Governance reforms are beginning to have an effect on the notoriously opaque and family-friendly corporate culture. Almost half of all directors are now independent and companies are starting to shed some of the excess cash they’d sat on. But these numbers mask problems. Judged by return on equity, corporate Japan is less profitable than any other advanced economy — not just the U.S., but also Europe and emerging markets.

All of this is driven by a conservative corporate culture. Families don’t want to surrender control, leaving many sectors wastefully over-competitive. To quote Nicholas Smith of CLSA Securities in Tokyo: "The main problem is margins, not balance sheet, for all the talk about buybacks. Low margins are caused by low market share and by maintaining noncore businesses that don’t pay their way.”

Takaichi has made clear that she wants to deal with this problem, but there’s a risk that pressures to reform will merely persuade companies that a public listing is no longer worth it. That could push them into the arms of (largely American) private equity buyers. Companies are leaving the Tokyo Stock Exchange at a record pace. The sight of long-established Japanese firms falling cheaply into the arms of U.S. raiders is unlikely to go down well with the Tokyo elites.

The foreign exchange market, crucially, is signaling that it believes that Japan hasn’t changed at all. The past week saw the yen drop more than 4% against the dollar, its worst performance since the pandemic — and a move that will likely antagonize an American administration convinced that the country is manipulating the currency lower. Forex traders are already talking of a "Takaichi Trade” and believe that any attempts at stimulus will merely create inflation and weaken the yen.

Politics

Takaichi’s party leadership victory was a bona fide surprise. Any number of myths surround her, but she dominated the national conversation throughout the campaign and many in the business community plainly wanted her to win. The LDP has run Japan with minimal interruptions since the war. Party insiders, who get to decide between the final two leadership contenders, believe she’s a risk worth taking.

Takaichi has a forceful personality that might even match Thatcher’s, and a similar determination to execute change. But she doesn’t have a majority in parliament and the fragility of her position was made brutally clear when Komeito walked out after 26 years.

However Takaichi resolves the impasse, she will not command Thatcher’s degree of freedom. She also inherits a much more complicated situation, from the aging of the population — the median age is now 49 years and eight months — to relations with China, which has demonstrated the ability to undercut almost any local exporter on price.

Tentative moves to admit more foreign workers are sparking the same kind of political backlash seen in the U.S. and Europe. If she can deal with foreign exchange markets, corral restive politicians and find a way to co-exist with both the U.S. and China, Takaichi might just bring Japan’s hypothermic age to an end. But if there were any doubt that extracting the country from its deep freeze will be difficult, the collapse of her coalition has ended it.