Lessons From The Past

Lessons from the past- What can we learn from history?

History has a tendency to repeat itself across all financial markets, creating both insights in to future performance as well as new opportunities for investment. These cyclical highs and lows have the ability to influence the economy as a whole and form extremes which can be described as ‘boom’ and ‘bust’ periods within the cycle.

The similarities in conditions between these historical cycles can allow a future projection of what may happen based on similar experience or circumstances and this knowledge is valuable for both policy makers as well as individual investors in forming an investment strategy.

Historically, markets can therefore be seen to go through phases reflecting similar patterns of activity which have previously occurred. A recent example of this was the period ofglobal recession, following a widespread financial crisis and which shared many of the characteristics and subsequent policy measures of previous global recessions.

This experience informs us that, for example, a slowdown in economic growth will make interest increases more unlikely and this will subsequently have a negative effect on the medium-term value the currency. It can also be seen that, according to the previous experiences of other countries and economies,we can draw parallels to try to predict the likely impact when these similarities emerge.

Although there are many examples of economic experiences which have been seen to repeat themselves in recent history, it is often harder to draw these parallels against events which are currently playing out in the real-time world markets. In order to understand the potential future performance of a region or economy, economists and investors attempt to take each situation in to account and appreciate that,whilst differences will invariably exist, the similar fundamental situations often create a very similar outcome.

In today’s global economy, some economists are drawing strong parallels between China’s current economic situation and that experienced by Japan in its rise and subsequent decline since the1970’s. Japan’s cycle begins from the end of the Second World War where it experienced twenty five years of booming, export-led growth through a controlled financial and banking-centred system. Although the intervention of the state in financial and economic matters in Japan was less-obvious than in China today, it had a similar intention to actively maintain economic conditions conducive to international trade.   

After a period of aggressive export led-growth, Japan moved with the pressure of domestic consumer demand as its investors became hugely wealthy and its consumer class more affluent. Japan then began to liberalize its regulated financial system as investors in Japan began to look to manage their wealth, the stock market and other assets began to boom. In China today, comparative years of rapid economic growth have also developed pressure from the growing middle class to consume as well as import products. Investment is also swelling from decades of export growth and stocks are reaching previously-unseen highs.

The involvement of the Japanese government in both trying to sustain stock prices and introducing aquasi-liberalization of its economy during the 1980’s is the basis of an important comparison with contemporary China. The mismanagement, and uncontrollable selection of liberal market strategies in the wake of years of solid economic growth that Japan experienced during this period is a trap that initially the Chinese had been keen to avoid but have somehow found themselves uncomfortably close.

This economic trap included engaging with capital market structures whilst fueling stock market growth to record-highs and creating asset bubbles as investors pile in to property and stocks. China has also experienced a booming stock market and rising property prices suggesting to some economists that it too has formed clear asset bubbles which are largely unsustainable.

Following the formation of these bubbles, Japan’s history becomes more of a serious concern for the Chinese government. Through the use of interventionist strategies, such as supporting stock prices, inter-company support and allow bad bank loans to be supported, the Japanese kept the larger problem of deflation at bay whilst supporting the asset bubbles within the economy. It was only once the extent of the problems in the underlying economy became apparent,with large banking losses creating a financial hole underneath high asset prices that the stock market again began to tumble and these asset prices also fell.

The extent to which China is following a similar path to that experienced by Japan during the 1990´s is fairly remarkable.

The recent stock market fall, seen as a modest correction by Chinese policy makers who have intervened several times in the market over the past few months, has the hallmarks of the bursting of an asset bubble in an economy which may not be able to support inflated values.The use of around 200 billion US Dollars by the Chinese government to prop up prices which fell around 40% over a few months shows a dangerous lack of real market demand.

If, as in Japan, investors lose faith in the markets and, in particular, become concerned that the government is temporarily supporting unsustainable asset prices, the value of Chinese stocks could fall much further. How much of an international event this would become, with China’s stock market only representing a relatively small portion of its economy, would remain to be seen. However, the precedent for governmental economic mismanagement will have been set and investor sentiment could be eroded throughout a deflating economy.

The deflationary pressure experienced in the Japanese market during the 1990’sforced the Japanese government to undertake an aggressive monetary policy strategy to reduce interest rates. Since it was hoped that lower interest rates would re-stimulate the ailing economy through the provision of cheap loans and credit, interest rates dropped 6% points between 1991 and 2000. The arrival of the Asian financial crisis in 1997 prior to the Dot Com bubble, meant that Japanese interest rates were famously held at 0% by the end of the decade.

Some economists have also pointed out that this deflationary situation within the Japanese economy from 2000 could also serve as a lesson for the US Federal Reserve, and the monetary policy that it chooses to employ, as global deflationary pressure fails to be alleviated and China struggles to retain its previous levels of global demand. Despite the impressive performance of the US economy since the financial crisis, the global decrease in prices following Chinese devaluation of the Yuan and the sharp fall in commodity prices, are likely to heavily influence its decision to raise interest rates.

Although the economy was largely set for a raise from 0.25 points, the impact that this would have on the US dollar, stock market and ultimately inflation has become a strong-enough argument for the FED to maintain rates at their current level.

Taking the example of Japan in a similar situation in 2000, prior to the Dot Com bubble, which forced a period of deflation in both Europe and the US, the positive signals of recovery in the form of rising inflation in Japan resulted in the first interest rate rise in years. In hindsight this was a mistake, as the global downturn shortly after caused renewed deflationary pressure and forced this decision to be reversed. Looking at this with regards to the current US situation, parallels can be drawn when the US economy is put in to the context of the wider global economy.

Despite being the most powerful economy in the world, in an increasingly interconnected global economic system it would not be immune from deflationary pressure should China and the wider commodity market continue to lead the global slump in demand.

Another example of recent Japanese monetary policy which can offer guidance to the Federal Reserve when comparing the US economy today, is the movement to tighten money supply too quickly as an economy improves. In 2006 the Bank of Japan began reeling in the Quantitative Easing program which has, seemingly, helped generate enough inflation to push interest rates to a near-decade high of  0.5% by 2007.

Japan’s policy makers had seen the economy begin to improve following the Dot Com bubble and its inflation rate had been growing whilst the Yen remained relatively low. This was taken as an opportune time to increase rates and begin to withdraw money from the economy. However, when the financial crisis struck in 2008, the requirement to stimulate the economy demanded that interest rates were soon reduced, yet again, by Japans policy makers.

Although it would be unfair to assume that Japan could have foreseen the financial crisis, the parallels with the US today is the existence of falling global demand and deflationary pressures. The lowering of commodity prices is likely to negatively impact domestic inflation in the US which, alongside rising demand for a strengthening US dollar, will have the likely effect of stalling growth. As the global economies begin to produce tentatively positive growth figures, it may be premature for policymakers to consider capping this with raised interest rates.

The US Federal Reserve may be luckier than the Bank of Japan in that there are indicators of global demand which are also beginning to show initial signs of weakness including lows in commodity prices and actions such as the devaluation of the Yuan. The US Federal Reserve may need to adapt by resisting the restriction of credit in the economy in anticipation of a dis-inflationary global environment.With inflation currently below the 2% target at around 1.7%, the temptation to raise interest rates should therefore be tempered by revisiting the Bank of Japan’s recent decisions.

Fotis Papatheofanous MBA