Japan, The Land of the Rising Sun – 07 May 2014
Following a positive year for developed market equities many investors have adopted the view that a repeat of 2013’s performance is unlikely, and have instead turned their attention toward the question of whether or not global indices will be able to eek out any growth at all.
A case under the spotlight in particular is Japan. With the NIKKEI’s out performance leading to a 57% gain for early investors over the 18 months to December 2013, many now appear to be of the opinion that the Japan story is over from an investment perspective. In this report we look at the impact to date of Abenomics and address the question of what more there is to be achieved by investors in Japan, if anything.
Two decades of deflation, a Titanic of turnarounds and the details of Abe’s Three Arrows policy
The closing stages of 2012 proved a pivotal moment for Japan, ushering in a new era among the upper echelons of government and monetary policy. This saw Shinzo Abe voted into the Prime Minister’s chair for the second time, while his Liberal Democratic Party gained control of both houses in Parliament following a landslide election.
The rotation of leadership led to fundamental changes at the top of the BOJ (Bank of Japan as the second-time Prime Minister prepared to execute one of the most ambitious economic reform programs to have been undertaken in the modern world.
This saw Abe set out to rid Japan of the deflationary malaise that drove the nation’s benchmark equity index into a 25 year bear market, dragging with it consumer incomes, real asset prices and confidence in the longer term prospects of the economy.
The flagship of the Prime Minister’s strategy has been a group of policies which draw their origins from Japanese mythology; the Three Arrows program. Japanese history holds that a Samurai warrior, Mori Motonari (1497 – 1571), attempted to resolve a dispute between his three sons Takamoto, Motaharu and Takakage by teaching them a lesson in unity.
In order to do this he first gave each of them one arrow and an instruction to snap it in half. Once each of the sons had done as they were instructed, he then gave them three arrows as a bundle along with an instruction to break them. Each of the warrior sons found it considerably more difficult to break the arrows once they were taken together than they had done when instructed to snap a single arrow alone.
The takeaway from the story, and its relevance to Abe’s policies, is that individually each policy arrow may be weak and unlikely to achieve the government’s objectives alone however; a combination of the three together will be likely to achieve a lot more.
The Three Arrows programme is a structured combination of fiscal and monetary policy measures which are designed to achieve the following objectives.
Comprised primarily of Quantitative Easing, was designed to increase the Japanese monetary base, while improving liquidity within the financial system and ultimately creating the basic conditions necessary for some form of inflation to take hold and eventually reach the 2% target.The Three Arrows programe is a structured combination of fiscal and monetary policy measures which are designed to achieve the following objectives.
This has seen the government introduce a range of fiscal policies designed to both stimulate the economy while improving the government’s finances. These include higher allocations to infrastructure renewal and development as well as increases to the consumption tax (VAT equiv) to mitigate the effects of the aforementioned measures upon the government’s balance sheet.
The consumption tax, a bone of contention among investors, was raised from 5% – 8% on the 1 April 2014 while a further increase is scheduled for 01 October 2015. The second increase sees the tax rise from 8% to 10%.
The final policy arrow of Abe’s program sees the Prime Minister embark upon a series of structural reforms which are designed to strengthen the competitive proposition of the economy and facilitate a return to long term sustainable growth. Included in the reforms is the deregulation of labour markets, a move which is intended to make it easier for companies to hire and fire workers, resulting in a more fluid movement of labour throughout the economy.
In addition to this, the government hopes to enact further policies that will encourage more women into work. This comes as part of a wider effort to re-engineer the workforce so that it is able to provide the necessary tax base in order to support the world’s oldest population during retirement and to make good upon the world’s largest sovereign debt pile (260% GDP).
This is a crucial step as it is estimated that Japan’s population will be 25% smaller by 2055, while 38% of the remaining number are, by this time, expected to be over the age of 65. The current government hopes to be able to achieve its fiscal ambitions, and future security, without opening Japan’s borders to mass immigration. Whether this will be possible remains to be seen.
This led to a significant devaluation in the yen (JPY) and strong inflows into JPY equities over 2013. Whether the eventual inflation would be artificial or not was irrespective of the government and BOJ’s intentions.
25 YR View of the NIKKEI 225
Major currencies gain upon the yen (GBP, USD, EUR, CHF // JPY)
USD/JPY ^ 22% over 2013 / / ^ 35% over 24 months
Three Arrows steering economy in the right direction, reignites inflation but more work still to be done
Although the government’s efforts are yet to see the NIKKEI break the back of a downward trend which has gripped the index for 25 years, they have made notable progress in steering both the market, as well as the economy in the right direction.
This is as 2013 saw Core CPI inflation demonstrate consistent positive growth, while the unemployment rate fell to a six year low and expectations for GDP over the coming quarters also improved. In addition to this, retail sales in Japan reached a six year high in February of 2014, while the pace of decline in the average of hourly earnings for Japanese workers also began to show signs of slowing.
The improving data, along with monetary stimulus from the BOJ, have each helped to drive a steep devaluation in the yen (18% ) and strong gains in the NIKKEI 225 (40% from trough to peak). Despite the positive developments, questions and doubts now surround what many investors now believe to be the likely future path of Japanese equities.
Infographic by JP Morgan Asset Management
The problem with Japan and risks ahead for JPY equities
Despite unprecedented monetary stimulus and the air of positivity which prevailed over Japanese equities during 2013, some investors have questioned the sustainability of an economic renaissance.
This is because concerns still exist over the pace of wage growth when bench marked against the increasing rate of inflation, which highlights the primary risk facing Japanese policy makers in their quest to reflate the economy.
The fact that Core CPI is expected to reach 1.7% by 2015 while wages are yet to demonstrate any real terms (adjusted for CPI) increase has had investors worried ahead of a hike in the JPY consumption tax which took place at the beginning of April. The core reason behind investors concerns is that if wage growth is to remain stagnant while prices within the economy continue to rise, then consumers will effectively suffer from a real terms reduction in income. The obvious consequence to have emerged from this is that if incomes fall further during a period of accelerating prices then consumers may retrench back into old habits of minimal spending. This could in turn have an adverse impact upon growth and potentially derail the recovery.
Should this scenario evolve into a reality then the BOJ would be forced to further expand its stimulus program which could then prompt the start of an unhealthy cycle that ultimately ends in defeat for all parties in the equation.
The key to resolving the conundrum appears to be in addressing the issue of persistently declining wages in Japan. This is something that both the BOJ and Abe’s government are well attuned to.
As part of efforts to counter the problem the Prime Minister has spoken publicly about the need for Japanese business, as a key stakeholder, to shoulder its share of the burden in reforming the economy. This means taking on the risk of raising wages for workers without any guarantee that the Prime Minister’s grand plan will work for business, the consumer or the economy.
So far the response has been relatively muted from the SME sector which employs the majority of Japanese workers. However, the stalwarts of corporate Japan such as Toyota, Panasonic and Hitachi have all led from the front by increasing employee pay in line with Core CPI inflation or above.
This is a positive development for the nation and should encourage the lower tiers of the business community to follow suit when conditions enable them to do so.
Can household financial assets help guide Japanese shares into clearer waters?
While it is possible that the consumption tax increase will dampen spending over the near term, there are some positives to arise from gradually increasing inflation. One of these is the impact that the aforementioned dynamic are likely to have upon the behaviour of Japanese savers and investors.
Given that JGB’s (Japanese Government Bond) are likely to remain flat due to the ongoing purchase program by the BOJ, while inflation trends upwards; Japanese investors are facing the prospect of negative real returns upon an asset class which has formed the foundation stone of many private and institutional portfolios for decades.
This can be expected to ensure that investors remain as yield hungry as ever throughout the coming years. Already, the government has began to consider altering legislation to allow the national state pension fund to invest into a broader array of asset classes in order for it to avoid the pitfalls of a BOJ dominated bond market.
In addition to this, with the introduction of the NIPPON Individual Savings Account (ISA equivalent) in 2013, Japanese savers are now more incentivised than ever to look toward JPY stocks for investment returns.
If the current interest and inflation dynamics were to instigate portfolio rebalancing en-masse then, given that household financial assets are reported to be in the region of $17 trillion ($8 trillion cash deposits), the price positive effects for Japanese equity markets could potentially be significant.
So what does this mean for investors in Japan?
While Q1 2014 saw existing concerns over Japan lead to the highest level of outflows in foreign capital since 1989, and despite that business confidence indicators continue to point toward lower sales volumes over the remainder of the year; Japan remains an attractive long term proposition in our view.
This is because with JGB yields set to remain lower for longer, retail investors incentivised to consider the stock market for investment and changes in legislation designed to allow pension funds portfolios to include equities as well, there remains longer term support for higher levels on the NIKKEI 225.
In addition to this, any sustained slowdown in Japanese economic indicators will likely be met with further volleys of stimulus from the BOJ over the near to medium term, which would again be price positive for JPY stocks.
Further from here, the current prevailing pessimism surrounding the idea of investing in Japan, we feel, ignores the bigger picture. This is that the government’s main objective concerns fundamental change to the economic infrastructure of the nation and as a result; is likely to require time before sustainable benefits are accrued.
In summary, Shinzo Abe’s grand plan still faces unprecedented challenges over the coming months and will require time before it is likely to yield noteworthy and sustainable results. For this reason, we feel it is too early to write off the Japanese recovery as another failure that is fit only for the history books.
There also remains a strong supporting case for higher levels in Japanese stocks over the months and years ahead. This is while the NIKKEI, despite strong gains over the last 18 months, remains at a significant discount to the levels achieved in 1989 (NIKKEI: 38,978 in 1989 VS 13,986 today).
Whether or not Japanese stocks will return to the highs achieved two decades ago remains to be seen, however; the discount of current prices to these levels could be taken as an indication of the potential gains on offer for investors with positions in the many index tracking funds which are available today.
The contents of this report and the Stockatonia website (https://www.stockatonia.co.uk/