One of the most fascinating aspects of current markets around the world is the degree to which central banks appear to be influencing the movement of not only bond markets but also equity markets. The erroneous belief that higher interest rates always cause stock markets to decline and low rates always cause them to rise is widely held, so pronouncements on interest rates by central banks have added to market volatility. While we wait to see if the US Federal Reserve (Fed) will raise interest rates at its December policy meeting, you can see in the chart below that US interest rate increases haven’t always resulted in lower performance for emerging markets generally. So while short-term volatility could be expected, we don’t anticipate that a mild increase in US interest rates would have a significant impact on the financial markets, particularly when many other central banks around the world remain in easing mode. However, making predictions about short-term market movement is fraught with many possible errors, so it’s important to keep our eye on the long-term developments.
Japan: A Case Study
Meanwhile, Japan offers an interesting case study of how monetary easing has affected its equity market and economy. The objectives of increasing inflation expectations with lower rates has not worked in Japan, so it is now taking a different tack by attempting to raise stock prices—thus putting money directly in the hands of consumers—through stock market appreciation in the hopes of spurring spending. The Bank of Japan (BOJ) has been purchasing assets including exchange-traded funds (ETFs) and thus, indirectly, company stocks.
While the BOJ elected not to cut interest rates or expand its current stimulus program further at its November policy meeting, BOJ Governor Haruhiko Kuroda said the central bank is ready to deploy “all available means” to hit its 2% inflation target, which means more actions to stimulate the economy may be coming. From a policy perspective, efforts to weaken Japan’s currency by lowering interest rates to negative levels has not worked and has attracted criticism, particularly from financial institutions. It seems that now the emphasis will be on weakening the yen as well as propping up stock prices. In the parlance of the gambling community, the BOJ has become the biggest “whale” in the market, holding a large share of stocks listed on the Tokyo Stock Market. Therefore, many investors have become increasingly focused not on company fundamentals but on the BOJ’s daily purchases. The central bank is buying ETFs according to the market weights of Japan’s Nikkei 225, the Topix and the smaller JPX 400 indexes. A decline in the yen versus the US dollar has typically caused Japanese stocks to rally (and a rise in the yen has typically caused stocks to fall), but this relationship has weakened with the BOJ making asset purchases.
The BOJ buying program is designed to favor companies with good corporate governance such as those that have complied with the Tokyo Stock Exchange’s corporate governance code by reducing or eliminating corporate cross holdings by selling their holdings in other operating companies. In any case, it’s estimated that the BOJ now owns about 60% of Japan’s domestic ETFs and it’s expected the BOJ could continue purchasing more ETFs through 2017.1 The government pension investment fund has also announced that it will increase its allocation to domestic equities so that the pension fund’s purchases could potentially rival those of the central bank.