Analysis looks at similarities and differences between Europe now and Japan 20 years ago

Written by Ray Clancy

Thursday, 16 September 2010 09:33

Europe today has many similarities to Japan 20 year ago in terms of investment and real estate and but there are also striking differences which makes it unlikely that Europe will experience the same kind of financial trauma, according to a new analysis.

Stephen Macklow-Smith, senior portfolio manager within the European Behavioural Finance (BF) team at J.P. Morgan Asset Management Europe and Japan, believes that looking at the two situations is beneficial.

In an analysis comparing the two economic regions he looks at a number of factors. ‘Europe today has many obvious similarities with Japan 20 years ago. In 1990, after a decade of rising asset prices, Japan saw a demographic shift, with retirees growing and the work force pretty much static. In Europe a similar thing is happening in many countries, most notably Germany, Italy and Spain,’ he says.

He points out that by 1990 Japanese real estate prices had also become overvalued and the subsequent falls in real estate and land prices caused non-performing loans to increase, leading to problems in the banking sector.
‘We see echoes today of a similar problem in Europe, particularly in markets like Ireland and Spain, and to some extent Greece,’ he explains.

‘As in Europe today, the Japanese equity market fell sharply and rates of GDP growth declined, as did long term interest rates. Eventually the Japanese economy became mired in a deflationary mindset, which quantitative easing was not able to counteract. All this took place against a background in which most key decisions were taken behind closed doors at the Bank of Japan and the Ministry of Finance,’ he adds in his analysis.

A key question being asked is whether Europe is heading into the same deflationary mire as Japan did. ‘It’s striking to many commentators that, just as in Japan, the key discussions in the eurozone have also all been taking place behind closed doors in Brussels and Frankfurt, and the European Central Bank (ECB) is famously reticent about making its deliberations public,’ says Macklow-Smith.

‘Europe’s handling of the crisis has been often contrasted with the US, where the key actors in the financial crisis were publicly questioned on Capitol Hill in 2008 and 2009.’

But he also points out that the contrasts between Europe today and Japan in the 1990s are clear. One of the most striking differences concerns Corporate earnings strength. ‘The earnings dynamic in Europe is a great deal more powerful, as we have seen in the successful and savage cost cutting that has taken place and that is now resulting in renewed earnings growth,’ he points out.

Another is currency weakness. ‘The weaker euro is driving exports and European companies have worked hard to take market share in high growth developing economies,’ he says.

And also accommodative monetary policy. ‘The policy response to the credit crisis in Europe has been to ease dramatically and to start quantitative easing at a very early stage,’ he adds.

Also in lower asset price valuations. ‘The valuations of European equities and real estate are substantially lower than those of Japan at the peak.’

When it comes to interest rates he points out that Japan did eventually cut rates, and then moved to quantitative easing in the early 2000s, but this reversal in policy came many years into the crisis and crucially after deflation had taken hold. Whereas in Europe, by contrast, the Bank of England has undertaken direct quantitative easing operations and the ECB has expanded its balance sheet hugely in order to provide the necessary liquidity to the economy.

Property is another interesting issue. By the early 1990s Japanese condo prices, for example, were on average nearly 18 times average wages. Property prices reached levels far in excess of what we have seen in Europe. For example, in Spain, at the peak of the market in 2008 average house prices were less than eight times average incomes.

‘There is one further factor to throw into the mix,’ says Macklow-Smith. ‘One European country back in 1990 faced many of the same problems as Japan: highly valued real estate, a strengthening currency, and years of poor GDP growth, very low long-term interest rates, and a notoriously secretive approach to policy. That country was Switzerland.

‘Yet it only takes a glance at the difference in equity returns between Switzerland and Japan over the last 20 years to see how much better Switzerland has fared at tackling these problems. Eerie echoes make for provocative journalism, but they don’t tell the whole story.’