Well, it’s official: the BoJ is about to break the Japanese stock market.
We’ve gone to great lengths in these pages to document the extent to which the “Tokyo Whale” (as the BoJ has come to be known both in the Japanese equity and JGB markets) is on the fast track to owning a rather disconcerting percentage of the free float in some names and we’ve also been keen to remind you that Haruhiko Kuorda owns 75% of the entire Japanese ETF market.
This can be difficult to wrap one’s head around, given that it kind of makes you rethink everything you ever thought you knew about “free” markets and price discovery and perhaps more worryingly, it certainly suggests that what you see on your screen isn’t actually real.
If you need a refresher/crash course on the BoJ and ETFs, please see the following posts:
- Revisiting The “Tokyo Whale”
- Bank Of Japan’s ETF Holdings Surge 80% To Cartoonish 16,000,000,000,000 Yen
- The BoJ Will Own The Entire Free-Float Of Uniqlo Within 3 Years
We last checked in on Japan last week, when the latest CPI data underscored the contention that the BoJ will likely never hit their inflation target (something the bank itself implicitly admitted at its last meeting, when they pushed the expected date for “success” back to “around FY2019”).
This is how far away they are:
That despite the fact that Kuroda now owns something like 40% of JGBs in issue.
Getting back to the ETF purchases, this is how absurd it’s become:
They are on track to own the entire free float of the company that operates Uniqlo stores within 36 months.
Meanwhile, they’re suppressing volatility in Japanese stocks, which isn’t surprising given the well-known fact that they (quite literally) “buy the dips”:
And in case you were wondering whether they’re considering putting a stop to this crazy shit anytime soon, do recall these over-the-top soundbites from Kuroda’s June presser:
- “It’s possible in theory,” Kuroda says when asked about the chance that the BOJ would cut ETF purchases before reaching its 2 percent price target
- But “it’s generally unthinkable” that the BOJ would keep a part of its easing program and quit another as the whole program is designed to reach the price target, Kuroda says
Let that sink in. He literally said that it’s “possible in theory” that he’ll stop buying trillions in Japanese stocks, but even though it’s “theoretically possible” that he’ll come to his senses, it’s “generally unthinkable.”
Again, he actually said that. In front of reporters. In public.
So that brings us to a new note out from Citi, in which the bank endeavors to explain that in fact, the BoJ is going to end up “causing the number of shares circulating on the market to almost completely dry up for some stocks,” by “end-March 2019.”
In other words, they are going to break the Japanese stock market in less than 21 months (at the latest).
Is a technical change in ETF purchasing unavoidable?
One aspect of BoJ policy normalization that could roil the equity market in the near future would be the announcement of a reduction in (or cessation of) ETF purchases. In fact, we think there is little possibility that the BoJ will reduce ETF purchases over the next six to twelve months, but if it retains the current purchase methodology there could be technical difficulties for ETF establishment in the near future. We think the BoJ may need to soon change its purchase methodology to end purchases of ETFs linked to the Nikkei 225 and instead focus on ETFs linked to TOPIX in order to sustain ETF purchases.
The BoJ’s ETF purchases could be damaging the functioning of the equity market.It is well known that the BoJ buys ETFs on trading days when the morning close of TOPIX is below the closing price of the previous trading day. These BoJ ETF purchases therefore act as a built-in stabilizer for the equity market, and provide support in terms of supply/demand. This creates a type of downward rigidity in the equity market, and could potentially cause diversions between enterprise values and share prices. When valuations become more demanding, equity market participants are likely to be increasingly conscious of disparities between share prices and fair value. The current consensus is that the BoJ has only a limited influence on price formation in the equity market overall, but we think it undeniable that it could be causing pricing distortions between issues in specific sectors and disparities between share prices and enterprise value for individual names.
Also, the BoJ’s ETF purchases will reach their physical limits in a few years. Our estimates put the BoJ’s ETF holdings at ¥18.2bn on a market value basis as of end June 2017 (Figure 19). This equates to around 3% of the TSE market cap at that time, or some 4% after adjustment for free float. Compared to the BoJ’s holdings of around 40% of JGBs in issue, this may indicate that there is still ample room for further buying of ETFs. However, the problem is that the BoJ buys ETFs that track the Nikkei 225. This means that mainly in high priced stocks the BoJ holds 20% or more of market cap for 11 names, which rises to 33 names when looking at free float-adjusted market cap. If the BoJ maintains its current ETF purchase methodology then the number of shares circulating on the market will dry up for some stocks, causing technical problems for the establishment of ETFs that track benchmark indices. If the BoJ continues ETF purchases of the current amount using the same methodology, its holdings of ETFs will grow to around ¥24trn at end-March 2018 and about ¥31trn at end-March 2019 (Figure 21). This could cause the number shares circulating on the market to almost completely dry up for some stocks.
To avoid this risk, one option would be that the BoJ stops buying Nikkei 225 ETFs soon and shift to purchases of TOPIX ETFs. Currently, the BoJ is engaged in the “unintentional active management” of the high priced stocks in the Nikkei 225, and faces the medium-term risk of declines in the share prices of specific names. To ensure it has a reliable exit strategy, the BoJ may need to soon implement a “stealth operation” to substitute TOPIX-linked ETFs for Nikkei 225- linked ETFs. It may in the near future need to reduce or cease purchases of Nikkei-linked ETFs in order to ensure the sustainability of its ETF purchasing. We think the September meeting of Monetary Policy Board would be an appropriate time for this, as it will mark one year since the BoJ’s comprehensive assessment of its monetary policy.
Note that last bolded bit. You cannot mark an equity book “held to maturity.” Stocks don’t mature. Which means that they’re effectively engaged in a perpetual (and unimaginably ridiculous) effort to print money to buy shares in order to ensure that the value of the shares they already own doesn’t go down.
Please don’t let that be lost on you. This is real. That is actually happening.
Of course these posts always have to end the same way: by recalling Kuroda’s infamous 2015 “Pan” moment when he told a conference in Tokyo the following:
I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘The moment you doubt whether you can fly, you cease forever to be able to do it. Yes, what we need is a positive attitude and conviction.