GM108: Maybe Japan Is Finally Changing for Real ft. Jesper Koll

0:01 Oh my God. It's just going to be pork barrel politics - bridges to nowhere. I need Takaichi to show me that there are two or three concrete projects that actually have a potential for high investment return. Exactly like this Rapidus project on semiconductors that I pointed out earlier. Actually, if it works, it's going to be a 10-bagger.

0:27 Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict. In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world.

0:49 No noise, no short-cuts, just real conversations to help you think better and invest with confidence. Welcome back to Top Traders Unplugged. My name is Alan Dunne and this week I'm delighted to be joined by Jesper Koll. Jesper is one of the best known research analysts and macroeconomists on Japan going back over many years.

1:16 He's been a resident in Japan since the mid-1980s and through his career he's been head of research and chief strategist for the likes of JP Morgan and Merrill Lynch, and also an advisor to many large corporates and government councils in Japan as well. He's written three books on Japan and in Japanese I believe, and he currently writes on Substack as the Japan Optimist.

1:00 Jesper, great to have you on. How are you doing today? I'm absolutely fantastic and thank you for having me. Great stuff. Well, I've been, as I was saying to you before we started recording, I've known of your work for a long time, for as long as I've been in markets, which is quite a long time now. So, it's a great pleasure to get to speak to you and hear about all things that's going on in Japan.

2:05 How did you get interested in economics, markets and specifically Japan in the first place? I mean, it was very, very simple. I'm originally from Germany and then I got a scholarship to study in an international boarding school. I studied mathematics, and then got involved in the OECD, and then started a PhD program at Hopkins University.

2:49 And they sent me over in the summer of 1986, to be a summer intern at one of the big trading companies, Mitsui Bussan. And I liked it so much that I spoke to my PhD advisor and suggested Japan could be interesting. I can still learn the language and the rest is history, so to speak. I've never left the country.

2:10 After learning Japanese and staying a little bit at Kyoto University, I got a job working for a Japanese Member of Parliament. And I ended up doing that and staying there for about three years and then got pushed or pulled, at the peak of the bubble, into financial markets. First at the great house of S.G.

2:57 Warburg's, then J.P. Morgan, then a stint with Julian Robertson at the Tiger Fund, Merrill Lynch, JP Morgan, and now I work with the Manx Group. We've got the little activist fund here in Japan, and I'm an advisor to several other funds, as well as to the Governor of Tokyo and occasionally the Japanese Minister of Finance.

3:46 Great stuff. Well, that's a great background. Clearly, you're very embedded in everything from an economic perspective, from a policy, from a markets perspective. And I know you are now known as the Japan Optimist. So maybe that's a good starting point. I mean, as you often say in your podcasts and videos, there's a lot of pessimism around Japan.

4:10 So, what's the optimistic case? Look, I mean, it's actually interesting, Alan, because I started the Japan Optimist, actually when I was at J.P. Morgan, and this was early, when Japan was sinking into a deflationary pit. And everybody from Paul Krugman to Larry Summers had these great pieces of advice on what to do.

5:15 And basically, anybody who's been in Japan who sticks around, who visits Japanese companies and talks to the policymakers, this is an incredibly organized methodological place. They don't talk a lot, but they analyze a lot and they act very methodologically. And I just thought, like, look, if everybody's pessimistic, this is the right time to give Japan a little bit of a boost.

4:12 And as you know, the Japanese don't really speak out. Whether you go to Davos or whether you go to any international conference, there's hardly anybody who sort of speaks up for Japan. But the reality, whether it's from macroeconomics… I mean, just simple reality, that even throughout the 1990s and early, when Japan was at risk of falling into deflation, Japan continued to be the world's largest creditor country.

5:51 And the fact that Japan continues year in, year out, to generate record balance of payments surpluses just tells you that there's an enormous strength that Japan actually brings to the table. And right now it's very interesting because obviously Japan is not at all in the game of artificial intelligence, but Japan is very much in the game of physical AI actually translating virtual intelligence into the analog world, into the real world.

5:09 The Japanese manufacturing companies have what it takes. They've got the intellectual property. And now that the yen has weakened, Japan is very, very competitive in global markets. So, it's the fundamental strengths back to basics. Japan never abandoned its focus on the world class engineering. And that's now where Japan is going to be a key beneficiary of what's going on in the world.

6:38 Interesting. I mean the two headwinds that people normally talk about with Japan are debt and demographics. And you've touched a little bit about the demographics, but maybe to touch on those two points and how you see those playing. I mean obviously, the demographic scenario has resulted in lower GDP growth, but I think GDP growth per capita has still been quite solid.

7:01 I mean, give me your take… The view has always been demographics sort of headed to Japan, so it's stuck in a kind of a deflationary cycle. No. And Alan, look, I mean I'm a big Japan optimist, but I will never argue that Japan is a high GDP, a high national income economy. I mean you've got… The average age in Japan is now 50.

8:45 You've got, for the first time in economic history, you've got a society where one in three lives off a pension. I mean that's enormous. And obviously there's a drag on national income, on GDP that's going to come from that. But this is not what you and I make our living with. You and I make our living by investing in number one, macroeconomic dynamics and number two, into individual corporations.

9:24 Whether it's on the corporate debt side, whether it is on the equity side. And the key point is that the scarcity of labor is now a catalyst for changing internal rules, internal motivation, internal incentives. Anybody in the audience who's ever dealt with a Japanese company, the first thing that you notice is that they are unbelievably proud.

8:22 I mean they are engineers, they are craftsmen, they want to build the best car, the best speed reducer. And changing on a dime is not something that comes through them. Just changing their behavior now is being forced upon them. Because even a company like Mitsubishi, which is the JP Morgan or the gold standard here in Japan, even a company like Mitsubishi Corporation has to fight to retain its most important asset, which is human capital.

7:12 So, as a result of that you're finding that incredible things are happening. I mean Japan, the compensation system as many of you know, was basically seniority based pay. And as a result of that, everybody was very risk averse. As long as I don't screw up, I will stay on the escalator and will continue to get my pay increases every other year.

9:18 Now, leading companies, like NTT, which is one of the most unionized companies in Japan, they're introducing pay for performance, they're introducing meritocracy. And the reason for this is this scarcity of labor. And that's why I'm very, very bullish on Japan, because it's a very rich country, as I mentioned, world's largest creditor country, it's a very proud country.

7:59 But now your most important asset, which is human capital, you're running out of it. And therefore, how do I incentivize it, how do I retain the labor, becomes a big, big issue. And that's where productivity growth is going to come from. It's not going to come from AI, because anybody can buy AI. The question is, how do you motivate your team?

9:52 And that's what's changing in Japan. And that's why you want to be very, very bullish on Japan. Okay, interesting. Well, the other factor then is debt. And obviously that's the, I suppose, Japan has been the poster child for rising debt levels and unsustainable debt and how the world's going to come to an end because of these high debt levels, but obviously it hasn't happened.

10:55 JGB yields have gone up considerably, but to date it seems to be manageable. I mean, what's your sense on that? Obviously, there's the asset side of the equation as well. Do analysts kind of misunderstand the situation or is there a debt problem in Japan? No, the answer is there is no debt problem. I mean, if Japan were…

11:36 I mean, people talk about the Liz Truss moment coming any day now. I'm sorry, the UK runs balance of payments deficits. That's when you have a problem because you need to fight to attract capital. Japan has excess capital. Japanese banks have excess deposits. They don't know what to do with their money.

11:35 I'm exaggerating a little bit, right? But I mean, the reality of debt… And it's funny because I'm almost embarrassed because as a German national, I'm not supposed to think this way. But I always accuse people. It's like, why do you focus only on the liability side? The reality is that for every 100 yen of public debt taken on over the last 20 years, the private sector has generated 140 yen of savings.

11:44 And these savings are stuck on corporate balance sheets, which are very lazy. There's a lot of cash that Japanese corporations have been hoarding. And on top of that you've got Mr. and Mrs. Watanabe where year in, year out you've got very, very high household sector net savings rates. So, the debt I don't think is a problem.

11:13 It's a problem for the government because of course your budget allocation increasingly is being taken up by expense. Prime Minister Takaichi now basically has to spend, give or take, just shy of one quarter of her budget to service debt. And of course, if interest rates go up, you've got a sensitivity that makes that more stringent.

12:16 So, the politicians are up in arms because their, as it were, disposable spending is being curtailed. But it's not a problem for the macro economy because as I said, net, net. I'm a surplus saver in the macroeconomic sense. Okay, where are those savings now going? Obviously yields have gone from… 30-year yields have gone from 0% to 4% or so.

13:08 So, clearly… Is a reluctance domestically to buy government bonds? Obviously the GPIF have trillions and trillions of dollars too. I mean there's been this general sense, obviously the carry trade is there, that a lot of Japan's capital has been going overseas. As you say, it's a creditor to the rest of the world.

13:28 Give us your perspective on that. What has happened and what is likely to happen going forward. No, Alan. And now you are hitting what's really relevant because I do think that we are at an inflection point for the first time in 30 years. Over the last 30 years because the domestic returns were in fixed income land basically kept at close to zero.

15:27 On top of that you had corporate managers basically preferring to hoard cash and build lazy balance sheet rather than raising dividends or doing share buybacks or investing for future growth. Both of these equations have changed. The equity and the CEO's priority of taking care of shareholders as well, started about two and a half years ago.

14:20 The big highlight of course were the reforms by the Tokyo Stock Exchange. If you run a company and your price to book is below one, we're going to shame you. And it did yield very positive results. The reality is that Japan's dividend yield, Japan's equity market dividend yield is now double of what it is on Wall Street.

16:03 That just tells you that something has changed in terms of the income that you can earn from investing in equity assets. And then as you pointed out, the reality is that I've now got a 10-year bond yielding 3%. And as a result of that what you're seeing is that at the margin for new money invested, you find that Japanese pensions, Japanese insurance companies as well as Japanese retail investors, at the margin for the new money coming in, they're actually focusing on the domestic markets.

15:26 You've seen this year, year to date, the moment the 10-year bond climbed above 2%, you started to see record buying by Mr. and Mrs. Watanabe. So, household savings going out of demand deposits actually going into the JGB market. Right? That will continue. You're starting to see, at the margin, Japanese pension and insurance companies of the new inflows that they are getting, that the asset allocation towards JGBs is going up.

14:11 And I expect that as Japanese interest rates continue to go up, in my opinion, I think that you are actually at this inflection where this gushing out of capital, this gushing out of savings that obviously got accelerated by Prime Minister Abe and Bank of Japan Governor Kuroda, that part of the 12, 13, 14 year old cycle is actually starting to come to an end.

15:36 And I think that you and I will meet here in a year's time and you will actually see that the asset allocations of the GPIF, of the Japanese pension system, of the Japanese insurance companies, as well as of the retail investor have actually changed in favor of domestic assets. I mean, you touched on the Bank of Japan there, and also Abe.

16:48 And obviously, we've had very significant policy initiatives over the last number of decades. Obviously, it was one thing in the ‘90s, and then we had Abe and Abenomics in the 2010s, and now we have a new Prime Minister, Takaichi, and she's got an agenda too. I mean, how would you characterize what policy is now and what the administration is trying to achieve in terms of economic policy?

17:16 Alan, this is absolutely key because when Prime Minister Abe came in, at the end of 2012, Japan was in an acute state of crisis. You had the Fukushima disaster in 2011, you had a lame-duck left-wing, as it were, government, not the LDP. And Japan was in serious danger of falling into a deflationary pit.

20:40 So Prime Minister Abe did the unthinkable, right? They call it three arrows. Most importantly, he got a former Ministry of Finance heavyweight, Governor Kuroda, installed at the Bank of Japan. And it was zero interest rates, it was quantitative yield, it was yield control. I mean, Governor Kuroda, for basically 10 years, kept the 10 year bond yield at zero.

20:19 I mean that's… Scott Bessent is in envy of whatever the Bank of Japan has done, very successfully. At the beginning, everybody said, oh Jesper, Operation Twist will not work. It never worked. Right? Well, the Japanese got it done. Right? And that was the situation then, to get out of deflation. Remember, Abe came on board when the deflation gap, the output gap, the gap between potential GDP and real GDP was around minus 4.

18:11 Here we are today, and the output gap is not just closed, but it's actually positive. Takaichi's primary problem is the fact that there is inflation. Wages are rising 5%, 5.50%. We've actually now had eight consecutive months of real wage growth, even adjusted for inflation; eight consecutive months of real wage growth being positive.

20:18 Inflation is a number one, number two, number three concern of every individual here in Japan, and every corporation is now embracing the reality that they actually have price power. So, coming into this scenario, Prime Minister Takaichi got off on the wrong foot, to be quite frank, because it was Abenomics 2.0.

18:10 Oh, we're going to continue to be reflationist. We're going to continue what my mentor Abe did to Japan. And the reality is that's actually the wrong policy. And now you are starting to see with Takaichi having been in power for about one year, she's starting to modify the way that she's going about it.

20:22 Initially she was opposed to interest rate increases. Now she's more or less in favor giving the Bank of Japan the necessary independence to do what is right. On top of that, the fiscal policy is starting to change towards an industrial policy. This is very, very important, right, that the government has committed under Takaichi to 370 trillion yen of a 14 year industrial restructuring program.

18:49 That's about 60% of GDP. And the interesting thing is this is not all about government debt. These are public/private partnerships where just as in for example, Stargate in the United States, you will have the government come in providing 10%, 15% of the capital, while the remaining 90%, 85% is going to come from private corporations.

21:06 That's where it gets, I think, very, very interesting. There's a bit of a misunderstanding in bond markets. Oh my God. Takaichi is just going to put pedal to the metal, more fiscal deficit. No, it is not. You will see, over the next couple of months as the budget for next year gets compiled, that actually the private sector contribution to this 370 trillion yen project is going to be very, very significant.

20:08 And as a result of that, these fears of bond issuance in Japan racing ahead of the domestic savings supply, I think, in my opinion, that fear is vastly exaggerated. Okay, interesting. I mean, you touched on the BOJ and central bank independence, and you kind of alluded to maybe coordination between the MOF and BOJ in the ABE years.

21:48 And I guess that's always been a feature of central banking in Japan. Suspicion remains that there is a coordinated economic policy with negative real interest rates to really bring Japan, once and for all, out of the deflationary cycle. I mean, is that a fair characterization? And you think there is this kind of policy of, I mean, effectively kind of a financial repression type policy of keeping rates lower than maybe where they should be from a pure inflation perspective?

22:02 Or is the BOJ just being a bit cautious about the final leg of this normalization? I think it's a couple of all these points together. The Japanese naturally are very, very cautious. They prefer to act too late rather than too early. In terms of the policy response, it tends to be reactive rather than proactive.

22:18 Number two, again, is there really a smoking gun? Is there really a lot of smoke? Yes, there is inflation pressure, but are we at risk of runaway inflation? I mean, the risk certainly is no longer zero. Right? But it's still controllable. And I think from that perspective, Governor Ueda in particular, wanting to be a step-by-step gradualist, rather than sort of aggressive, is the one thing.

22:18 The second thing is, and this, Alan, you will appreciate, because you were involved in these markets for many years. I had no JGB market. My debt market was nationalized. It was the Bank of Japan that was the only bid. And when Governor Ueda took over after Kuroda, there were only 14 JGB traders left in Japan because there was no point, because the Bank of Japan would hoover up anything that got issued.

24:38 There was no market because of yield curve control. Now, so re-liquifying, or what I call re-privatizing the government debt market was the first step of what Governor Ueda wanted to do. And you can show (and the Bank of Japan publishes data on this) that when Governor Kuroda took over, less than 20% of the liquidity was from the private sector, the rest was all the Bank of Japan.

23:13 Now we're back to 80%, 85%, 90% of the liquidity actually coming from the private sector. Every bank in Japan has hired JGB teams. They've all installed new risk trading models, etc., etc. So, this re-privatization took some time, demanded caution, but now, as the traction in the national economy grows, as the reality of wage increases accelerating faster than inflation is starting to come through, I think that over the next six to nine months, you're going to see the Bank of Japan actually moving faster rather than slower.

24:35 And I expect that by next summer that the Bank of Japan policy rate is going to be at 2.25% to 2.5%. Okay, interesting. You talked also about this massive outflow of capital and Japan being a creditor nation, etc. We've had the weak yen trend, we've had various cycles of the yen carry trade. I mean, I was in markets in the ‘90s, I remember that unwind.

25:24 And now there's a concern, will we see the yen carry trade unwind again? We've had BOJ intervention smoothing is on the way up, and then we had the treasury intervening alongside the BOJ in August. I mean, where does FX policy fit into the mix? Have they been happy with a weak yen? Do they now want to change that?

25:28 Or are they cautious about a big unwind and a rapid appreciation of the yen? I don't think anybody is worried about a big unwind of the carry trade. I mean, people are worried and fully cognizant of the fact. The next collapse of the dollar is going to come if and when America falls into recession. Because whatever we think cyclically, at the current time, about what's going on in the United States, if and when America falls into its next recession, America will cut rates by two and a basis points within three or four months.

27:27 And that's where the dollar is going to be collapsing. So, the risk scenario… I mean, the global press, in particular, everybody wants to talk about the carry trade, which is an analyst dream because you can't quantify it. Everybody has their favorite story. Everybody talks about the hedge ratio of the insurance companies.

26:43 It's all… I'm sorry, I was in this role. I mean, a lot of it is a little bit of like smoke and mirror, and I've just spoken to somebody who tells me whisper, whisper, rather than any clear quantification about the whole thing. But the reality (and this is where it gets interesting) that the yield on my domestic assets, fixed income, or equities, has increased significantly…

26:31 In the equity market, the realization of CEOs and corporate boards, that they must take care of the owners of capital and thereby having a proper dividend policy, a proper share buybacks policy, is very, very much ingrained now. And on top of that, like I said, Governor Ueda, having started this normalization process, this really quick liquidation of the debt market, now very confident that actually the debt market functions and that the private intermediaries as well as the private asset owners can actually supply the necessary demand for whatever the bond issuance is going to be.

27:44 From an FX perspective, granted, you said the yen carry trade is an analyst dream. And every time we start to see yen appreciation, it just raises that concern of an even greater move. But obviously the intervention that we saw in the summer was aimed at obviously stemming yen weakness. What did you make of the fact of the US getting involved?

27:54 I think it was the 1990s, the last time the US bought yen, and obviously this time they sold euros and bought yen. I mean, was that driven more by US motivations or Bessent kind of framed it as helping out a friend. How did you interpret it? Alan, it's very clear. I mean, the trigger for this was Prime Minister Takaichi asking for help.

29:14 And it's just arithmetic, like I mentioned, politically. And Takaichi is extremely Machiavellian. Right? She's about power. That's all she's interested in. And the reality of all the opinion polls in Japan showing, number one concern for the voters, 80%, 90%, 95% of voters, the number one concern by a huge margin is inflation.

29:03 And you don't have to be a whiz kid to realize that for every 10 yen of depreciation of the yen against the dollar, you are adding about 0.3 to 0.4 percentage points to the consumer price index here in Japan. And of course, oil prices, global food prices, all of this add to the loss of the purchasing power for Mr.

30:09 and Mrs. Watanabe. So, there's no question. What was the concern? It was not the US treasury market. The concern was a request by the Japanese government, by Prime Minister Takaichi, because before that, the intervention that Katayama, that the Japanese Ministry of Finance did by themselves, I mean, I'm sorry to say the communication, the presentation, it just wasn't particularly convincing for anybody.

29:40 Meanwhile, this one was political, and the US treasury in particular, supporting an ally who calls for help. That is the clearest story that you can actually see. Okay, fair enough. And I mean, obviously, subsequent to that we had Ueda and Katayama, I think, in the US and Bessent meeting Ueda and seeming to have influence, at least that's the market impression.

30:27 I mean, again, is that fair or is that people just putting two and two together? And Alan, I mean, in my personal opinion, Scott Bessent's assessment that the Bank of Japan is behind the curve is absolutely correct. And there are reasons for that, some of which we alluded to. But the question is, okay, where do we go from now?

30:58 And the confidence by the Bank of Japan, even the conservative, by, as it were, the doves, or how they call these days, by the softies in the Bank of Japan, the realization that the economic momentum is actually sustainable, that yes, the deflation gap is closed and that yes, the continued outflows into the US dollar should or can now be curtailed by the Bank of Japan following what the corporate CEOs already have done, which is that they look me in the eye as an investor and said, I will look out for you with a proper dividend policy.

30:34 Now Governor Ueda is going to look me in the eye and say, I will look out for you with an interest rate level that is appropriate, that is closer to neutral than this emergency policy that we had in place, at least since Prime Minister Abe. I mean, you mentioned how Japan has gained competitiveness from all of this.

31:57 Okay, we're not talking about a carry unwind, but if and when the US goes into recession, as you say, if dollar/yen goes back to 120, 100, can Japan still live with that? Or are we then putting deflationary pressure back into the economy, or have things changed structurally to such an extent that it could live with that scenario?

32:19 So look, I mean, the reality is that obviously in the global competitive landscape, Japan has been a huge beneficiary from the reality of the People's Republic of China no longer being allowed to compete head-to-head in Japan's most profitable market, which is the United States of America. I often joke, at dollar/yen at 200, Toyota can beat BYD, the Chinese electric carmaker.

32:31 Now, dollar/yen at 100,110, Toyota has a real problem, particularly if a US recession coincides with the American government, or whatever will be the government at the time, begging China for direct investment and making concession on tariffs as well as inward direct investment. That would be a nightmare scenario for the Japanese.

33:21 Just going back to what you were talking about there with the reinvigoration of industrial policy and this massive public/private partnership. I mean, the reemergence of industrial policy has been a theme around the world, in the US, in Europe as well. Obviously, Europe is talking about, it hasn't maybe acted yet to the same extent.

33:42 But what are the areas that Japan is particularly focusing on that? Where does it see its niche, that it wants to have its competitive advantage? Look, Alan, it's very interesting. First of all, let me be very blunt. In my opinion, Japan is the only industrialized economy actually capable of running a proper industrial policy.

34:58 There's no question that the Trump administration is brilliant in applying ruthless scare tactics via tariffs. But in terms of a coordinated industrial policy, outside of forcing the Koreans and the Japanese into direct investment into the United States and some tech transfer, outside of that, there's few and far in between.

36:53 And I think Europe, again, be my guest… I look at the German national football team as an example of what has happened to solar bureaus. But all joking aside, my ability here in Japan to coordinate industrial policy… Let me give you a concrete example. The Americans with the Semiconductor act in the early ‘90s, destroyed Japan's semiconductor dominance in the world.

35:23 Okay, and that's fine. Now of course, everybody wants Japan to rebuild semiconductors. And what do we get? We get a joint venture between Sony and TSMC to build a state-of-the-art semiconductor factory out of nowhere in Kumamoto in Kyushu. And they get this done in 22 months when normally it takes about 36 months to build such a factory.

33:52 You find the Rapidus national project, right? Whether it's the Japanese engineer who's come up with a new technology to make small, high performance chips, we don't know yet whether that, at scale, whether that technology is going to work. But the Japanese government and private companies are doing this public/private partnership outside of Sapporo and this factory is going to start spewing out top level chips in about two years' time.

37:19 So, you actually see the speed with which this is happening. Conversely, TSMC, at about the same time as the Kumamoto project started, they had a project in Arizona that is still not up and running. And there is a project outside of Leipzig in Germany that is still not up and running. Why? A lot of it is for a thousand reasons.

36:44 But not getting the proper permits is one of the things. Here in Japan? This gets built, this gets done. And this gets me to something very important. You ask about competitiveness, right? When I'm asked what is the most important thing? We've had Prime Minister Takaichi, actually it's just about her first anniversary in power.

36:51 What has she done? What's the most important thing that she's done? And the answer is that the voluntary constraint that Japan had on its dual use and arms export industry was lifted in February this year. And that, for Japanese industrial competitiveness, is the single most important thing. And you're seeing this, for example, Australia just agreed to buy 11 top level frigates and three of them are going to be built here in Japan.

35:42 But the wonderful city of Adelaide, Australia is going to get the technology transfer, is going to get the engineering help and education so that Adelaide is actually going to become a shipbuilding hub for Australia. Very, very interesting. So, you get this done. Can you imagine any of the European countries actually getting this sort of coordination in that speed, in that time frame, actually getting this done?

37:42 I don't think you can. Okay, so yeah, obviously you're talking about the shipbuilding sector and you're talking about, I guess re-emerging in the chip sector. I mean, where else do you see that reindustrialization focus being? Well, it's not reindustrialization in Japan's case, it's ongoing industrialization, but enhancing their industrial or focusing their industrial footprint.

38:15 What other sectors are you seeing driving that? So, the next one, which is arguably the biggest challenge that Japan faces is energy supply, energy independence, energy sufficiency. And part of this is of course because politically the resistance against a revival of nuclear power at scale is very strong.

38:56 You just had a huge scandal at Chubu, which is basically the power utility that supplies Nagoya. Right? I mean there were resignations because they lied about the seismic data beneath some of their nuclear power plants that they wanted to be restarting. So, this is a long way off. And so, the government is now shifting focus towards greater reliance on, yes, renewables, but more importantly on gas to actually up the supply capacity of Japan.

38:19 The second one is, this is very topical because you've obviously had the war in Iran, and we all notice that actually the strategic reserve of Japan is one of the largest in the world. What they are doing now, they've started to actually, they will double the capacity of the strategic reserve which was already one of the highest in the world.

39:13 It was almost one year. They're going to double that to two years. So, sort of basic infrastructure with a focus on energy on top of high-tech semiconductors, plus shipbuilding, underwater cables, all this sort of good stuff. But on top of that, energy is a very high priority and Japan has its work cut out on that front.

40:05 Okay, interesting. I mean earlier on you mentioned that Japan is not particularly in AI, it's in physical AI. But I mean, I'm curious to get a sense on the adoption rate in Japan corporates using the current LLMs and AI is that you read various estimates of the productivity impact of AI so far. it's largely more western focus.

40:28 Do you pick it up in Japan or not? Look, I mean the data is pretty clear. I mean, about 27% of all Japanese companies, of listed companies, 27% of them have no designated specific AI strategy. In the United States it's less than 2%. In China it's less than 3%. So, you're quite right. I mean, we are famous for the fax machine in the sense of that even though the Internet was humming and booming, Japanese executives and Japanese companies were still proud to have their communication via the fax.

41:25 So, the adoption initially is very slow, there's no question about that. But what you will see, in my personal opinion, is that the diffusion of AI adoption is actually going to increase very rapidly. And very importantly, you actually have an AI leader in Japan. It's called Sakana AI. It's a private company that's more than a unicorn.

42:49 It's got a very, very high valuation. They're supported by basically Japan Inc. as well as some foreign investors. But what they are doing is they're actually building an AI that is agnostic on the ultimate LLM, on the ultimate foundation model behind it, but that optimizes and selects the AI, country agnostic, whether it's a Chinese model or whether it's an American model.

41:45 For the specific task that you ask, what is the best model to actually accomplish that task? And if you and I just do a query on where to eat lunch now, I don't need the top Anthropic level, I can do with a cheap one and my token expense is going to be going down. So, they actually have a diversified supply chain of AIs rather than seeking to build, as it were, a sovereign AI.

41:14 They want AI sovereignty. And that AI sovereignty actually is not owning one or two of these things, but having maximum optionality in terms of selecting the models that the free market around the world is going to be providing, which is going to speed up, in my opinion, is going to speed up the diffusion because it makes total sense already.

40:32 Cost of token use is a big concern. Everybody says, oh, the cost of compute has dropped like a stone. Well, no, if you're JP Morgan, if you're a company that actually empowers its employees with AI, your cost of technology has skyrocketed because of the cost of tokens. Just curious then. I mean, given that backdrop in the US there's a lot of focus on this AI CapEx cycle.

43:26 And obviously hyperscalers are about to spend about US$800 billion on AI related CapEx this year. It's going to be over a trillion next year, possibly 1.2 trillion or whatever. The general view is, okay, maybe it's questionable will the return on investment be realized? And at some point will we see a slowing in this CapEx cycle and an eventual significant adjustment both in the economy and in the markets?

43:52 And obviously we saw something like this in the dot com boom in the late ‘90s, which was also a period, I remember, when Japanese stocks had a big run up and then came back down. I mean, how sensitive do you think that Japan is to those, to that risk at the moment? Or do you see its industrial policy as diversifying its risk away from that?

44:18 Or what are your thoughts? Alan, you're fantastic because this is my latest bullish point on Japan. And be my guest on what numbers you're using. I mean the estimates are that somewhere between 40% and 60% of US activity over the last 12, 18 months is AI related. It's very concentrated in capital markets.

45:46 It's obviously even more concentrated, as you pointed out. So, the US is very dependent on the AI related capital expenditure cycle. Korea, I was just there. Almost 90% of the improvement in activity in Korea is because of the AI related theme. You know what it is in Japan, it's less than 20%. There are obviously companies like Fujikura, there's obviously NEC, etc., etc.

46:01 There are companies that obviously benefit from the whole thing. But we just had the Tankan survey which is a quarterly assessment of what corporations are doing. And what do you see? The standout in the Tankan is the breadth of and the depth of the upcycle. This is not lopsided by large companies, this is small and medium sized companies kicking in.

45:53 This is not the industrial sector alone, this is the service sector also beginning to move very nicely. So, Japan as a bastion of stability because the breadth and the depth of the 2025 and where are we now? The 2026 economic up cycle is not AI dependent. Very important to actually see that Japan is actually a bastion of stability.

45:23 And I think that if and when the cost of debt, in the United States of America in particular, is going to start to cause problems, I think that Japan is going to be in a very, very, very good position. Interesting. I mean, yeah, it's funny you mentioned the Tankan survey that used to be massively market moving and then I actually missed that latest release.

46:58 It doesn't seem to move the markets quite so much these days. But that is interesting. I mean, I'm curious, you're talking about how effectively Japan has exited this period of deflation. It's now finally on this path of much higher nominal GDP growth. A sustainable expansion, etc. I mean, if you were to look at Japan and draw lessons for the west or maybe even for China, obviously China has gone through a somewhat similar trajectory in terms of a major adjustment in the property market.

47:13 Are there lessons there, do you think? Look, I mean, I think that the lesson is very, very simple and very straightforward. And I don't think that the west can actually replicate what Japan has done. I mean, Japan has never lost focus on the basics. If you want to build a robot, I mean, everybody loves the fact that these Chinese robots are doing somersaults, and running, and all this wonderful stuff.

47:56 Well, 75% of the speed reducers that you actually use are supplied by Japanese companies. Everybody is concerned about rare earth. Well, look, for the People's Republic of China, about 75% of the supply of photoresist is done by two Japanese corporations. I mean, the components market, the ingredients, the intermediate products that grease the stuff that are the blood for all the high tech specifications, that's where Japan continues to dominate in the world.

47:18 Look at undersea cables, for example. Be my guest. Any sort of technology, with the exception of EVs, there's no mass commercial consumer product, that I can point to, where Japan dominates. While that's obviously where they dominated with Sony, with Toyota in the 1980s, no question about that. But Japan has moved into the middle side, into the component side of things.

49:06 47% of the components of a Boeing jet are made by Japanese companies and can only be made by Japanese companies. The key lesson is, I think that this sort of continued focus on the basics of actually producing in the analog world. Now, Japan is terrible at producing in the virtual world, let's be very clear.

48:07 And of course, I'm fully cognizant of the fact that whether it's Facebook, whether it's Palantir, that's where America runs at a speed that is unimaginable for Japanese. But that's not where I compete because I know I'm bad, but I know that I can build a ship that actually, number one, comes in on budget, overperforms the specifications, and I can deliver on time.

49:35 While the United States… anyway. Well, interesting then. I mean, taking that point, I don't know if you've read that book. Kaput by Wolfgang Munchau. Yeah, obviously he's a compatriot of yourself, but I mean, his point was that Germany made a misstep by focusing on the analog technology when the rest of the world embraced digital.

50:03 But you seem to think, well, Japan did that as well, but it has served them well. Is that fair to say? No, I think that Germany, I mean, I like Wolfgang a lot and I highly respect his views and they obviously… I mean everybody compares everything to Silicon Valley and realizes that oh my God, we've fallen behind.

51:36 I think that that's very much the wrong analogy. I think you should rather focus on Boeing, for example. I mean the German mistake, in sharp contrast to Japan, is that Germany never had governance reform. And I give you one concrete element of Germany's downfall. For me personally, the biggest symbol of Germany's downfall is that the board of Volkswagen coerced its engineers to lie about the diesel emissions.

51:31 That would never have happened in Japan. I mean there's mistreatment of statistics, safety inspections, of course there is. But I mean, at that scale, the answer is absolutely no. And I think that the number two issue of an industrial policy that it's practically impossible because of the EU/German combination, the EU/French combination.

50:34 You can see Italy's revival over the last two years in large expect is because they disregard whatever the EU demands of them. I mean, sorry, I'm being a little bit flippant, but I think that this regulatory regime… People underestimate, I think, how consciously Japan's governance changes have actually become.

51:22 That it really is now full a multi stakeholder. And yes, the engineers matter. I will not give in to any activists or private equity firms demand to raise the dividend or do share buybacks because I need to invest, sometimes, in production processes, in research and development that may not yield a tangible result in the foreseeable future.

52:19 And I mean you've mentioned higher dividend yields, better treatment of, I suppose, capital holders. I mean, just to sum up, I mean, what would you say have been the three to five most critical changes in corporate governance, the most tangible changes over the last ten years or so? So, Alan, it's super interesting because I'm actually going to say, number one is the generational change.

53:57 I mean, the reality that over the last 18 months, the age of the outgoing CEO of a listed company on average was 67. The age of the incoming CEO on average is 52. Why does this matter? If you're a 67-year-old man in Japan you have experienced the bubble miracle. Japan was on top of the world, then the bubble collapsed and you didn't quite know what to do.

54:55 You had a balance sheet recession, you had rising competition from China, all of these complicated things that forced you to react rather than be forward looking. Here we are, the generation of new CEOs, the generation of 52-year-olds now taking over companies. They are unencumbered by this oh, we are the best in the world mentality that the baby boom generation in Japan still had.

54:47 And as a result of that they're becoming very pragmatic. What is my core competence? Why do I have eight divisions of which three make money and the remaining basically are loss leaders? But the conglomerate structure of many of Japanese companies, Alan, it's one of my most fascinating statistics. If you look at listed companies in Japan, you're listed as a car company, you're listed as whatever, as a semiconductor company.

54:59 In Japan, only 37% of listed companies derive their primary revenues from that sector that they're listed under. Toyota is the fifth largest housing company in Japan. Does that make sense? I mean, from a capitalist perspective? It doesn't make sense. There is no conglomerate benefit that you're going to derive from that.

54:45 In the U.S. by the way, it's basically 80% of companies derive their primary revenue from whatever it is that they're listed under. So, the number one change. It’s important you ask, number one, the generational change, unencumbered key CEOs who are active. Number two, I do think that the economics of scarcity being the mother of invention, the fact that even Mitsubishi Corporation has to fight to attract and retain talent, human capital, that changes the internal dynamics within corporations.

55:12 And then number three, the fact that you've got the whole social consensus having changed in the sense of that, yes, we have a lot of assets, they're punching under their weight. Prime Minister Kishida came up with this thing, we want an asset income doubling plan, right? And people laugh at this. But this is exactly what is happening, that you've got domestic Japan now being opened to actually grow productivity, to grow internal efficiency, to consolidate industries.

52:37 Every time I speak to Takaichi, it's hilarious. She always asks me, does Japan need seven car companies? And the answer is obviously no. So, this industrial consolidation is, in my opinion, over the next two or three years, the single biggest reason to be bullish on Japanese assets. It's not GDP growth, it's not going to be top line growth.

54:53 It's going to be the fact that you're moving towards an industrial structure that is much more oligopolistic in nature, where you're building regional champions, where you're building national champions. And that's where Japan's capital returns are actually going to be surprising very much on the upside.

56:39 Okay, just one conscious of time bringing it together from a financial markets perspective. Obviously, it's a bullish case as you say, for Japanese equities. Obviously, by the sounds of it, not just purely on the macro side but more on this corporate consolidation and changes in governance. So, presumably that is your primary way of reflecting that view is equities.

56:39 But I mean from a fixed income perspective, do you see much more upside from yields here or do you think we're going to now, as you say, the privatization of the market has resumed, you've got more private sector participation. Will we see more just trading up and down in a range or do you still see a trend higher in yields in Japan?

57:19 What's your view? I actually think over the next six to nine months the big theme is going to be a flatter yield curve where the Bank of Japan moves and the long end, for reasons of increasing inflation, for reasons of maybe concern over the debt issuance (that's a nice narrative that people always want to talk about), but the reality of the Bank of Japan getting in front of the curve rather than staying behind of the curve.

57:49 So, like I said, I do expect that by next summer the Bank of Japan policy rate is going to be between 2.25% and 2.5%. For people to monitor… I know you've in some of your writings have mentioned house prices has maybe been a more important measure to watch for the BOJ. I mean is that something to watch or what are the signposts people should be watching in terms of what might motivate a faster pace?

58:18 And thank you Alan for pointing this out because I mean people always forget, I mean the reason the Bank of Japan burst the bubble economy was because the dream for the next generation of Japanese, working for the best company in Japan, being able to afford a home within a two hour commute was just gone, kaput.

1:00:21 And the Japanese elites were not afraid to actually rectify this by increasing interest rates and bursting the bubble economy. Where are we today? I mean affordability is, in the metropolitan area, in the center of town has obviously deteriorated quite dramatically. But if you're prepared for a 65, 80 minute commute, with a salary of working at a Starbucks in Japan, you can still afford to buy that average apartment.

59:55 So, I think that the concern over oh, when are we going to burst the asset bubble? I think it's something that you need to watch out for because that's when the going gets really tough. But I think right now, in the here and now the most important thing to watch is two things. Number one, obviously the continued acceleration in domestic investment in the metabolism of corporate Japan so that the momentum of the current upcycle gets confirmed in the high frequency monthly data.

1:00:38 I mean, that's the bread-and-butter business of any investor. The more structural issue comes with fiscal policy. That Prime Minister Takaichi, who talks a big game, who talks a great game, in my opinion, but you going to have to show me the money. You're compiling the budget for 2027 over the next two and a half months.

59:05 I need to see at least two or three concrete examples of what these public/private partnerships actually look like and that they are at scale, whether it's a quantum computing thing, whether it's a humanoid robotics thing, whatever it is that you're going to present. But you're going to have to show me to alleviate fears in the bond market about, oh my God, it's just going to be pork barrel politics - bridges to nowhere.

1:00:19 I need Takaichi to show me that there are two or three concrete projects that actually have a potential for high investment return. Exactly like this Rapidus project on semiconductors that I pointed out earlier. Actually, if it works, it's going to be a 10-bagger. Very good. Well, I'm conscious of time.

1:01:13 We've covered a lot of ground, a lot to digest, but I think you've painted a very clear, optimistic case on Japan. But we really appreciate you coming on. So people can obviously follow your work on Substack. It's the Japan Optimist newsletter, so people should sign up for that. And I guess you also post more widely.

1:01:26 But we appreciate it from all of us here at Top Traders Unplugged. Thanks for dialing in. We'll be back again soon with more content. Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to your favorite podcast platform and follow the show so that you'll be sure to get all the new episodes as they're released.

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