Following a recent trip to Japan, Sean Yakota, head of Asia Strategy at SEB has commented on the changes he has witnessed as Prime Minister Shinzo Abe’s stringent economic changes increasingly begin to show signs of success.
Yakota reports that deflation pressures are fading in Japan and are acting as a powerful shift that makes equities the most promising asset class. “Many that we spoke to are positive for several reasons. First, Japanese corporates are very competitive from cutting costs for over a decade. Deflation has forced corporates to slimdown and clean-up their balance sheet. Corporate Japan has become very competitive compared to global peers. Second, rise in asset prices especially in land has positive knock-on effects.”
At the peak of the bubble in 1989, the value of equity and land was above USD30 trillion but that has almost halved to USD17 trillion, Yakota reports. “Land prices in Tokyo increased 3.2 per cent in 2014 and with the surge in equity market, households and corporates feel wealthier.”
His third point is that Japanese corporates now talk about ROE. “Foreign investors historically and rightfully criticized that Japanese management never cared about ROE. That is changing and anecdotally you see “ROE” mentioned more in newspapers. More importantly, the introduction of JPX Nikkei Index 400, where ROE and profitability are the main selection criteria is changing where Japanese funds invest. BoJ buys ETFs based on this index to reward companies who focus on ROE and GPIF now includes this index in its benchmark. The two hurdles people are watching on Nikkei are 20,833 (Apr 2000, high) and 22,667 (Jun 1996, high).”
Yakota also reports that the Government deficit is improving. “The biggest worry for international investors is the +240 per cent of GDP government debt. The issue is far from resolved but even in the darkest areas of the Japanese economy, we see a ray of light. The VAT tax hike from April 2014 has increased revenues by only 1 per cent of GDP but the rise in nominal GDP is helping the government’s debt projection. At this pace, the government’s goal of eliminating the primary deficit by 2020 looks achievable, something, which most, including your author doubted a several years back.”
Yakota believes that to meet the 2 per cent target by the first half of 2016, most expect the BoJ to do another round of stimulus and in his view the timing is dispersed from July 2015 to April 2016. “Most expect that Abe wants a rising CPI by the July 2016 Upper House election so that he can declare that deflation has been defeated. Abe wants to gain two-third majority in the Upper House (he’s coalition only has majority) so that he can amend the pacifist constitution. Economists’ estimates on the next QE timing vary because BoJ is hinging its monetary policy on inflation expectations, which are hard to measure, forward looking and sentiment driven. There is a large qualitative decision making layer on top of the incoming economic data, that makes BoJ decisions hard to predict. Hence, the last two QEs launched by BoJ were surprises to the market. What we do know is that BoJ will not wait for the data to improve and will have to pre-empt any deterioration in inflation expectations” he writes.
Looking forward, he believes that the relationship between Yen weakness and the rising Nikkei will break. The relative divergence in monetary policy between Japan and US will continue and weaken the Yen. “Our year-end target remains at 130. While the Fed’s pace of policy normalization may be unclear, the direction is set. For Japan, policy easing has to continue well after hitting the 2 per cent inflation target, which will prevent BoJ from tightening for all of 2016. “However, if the economy recovers, Japan exits deflation and corporate earnings continue to improve, the dynamics on Yen will have to change. The current account is already improving from lower energy prices and in the next 12 months, nuclear power plants will restart and further reduce Japan’s reliance on energy imports. Long end interest rates will rise if deflation sentiment disappears and demand for credit should also rise and push up rates. In this environment, relative policy differential between US and Japan should narrow and prevent USD/JPY from rising. Corporate Japan is already very happy with Yen at 120 and appears that anything over 110 is enough as long as Japan is no longer in deflation. In this scenario, we think the correlation between Nikkei and JPY will break where we’ll see Nikkei continuing to rise but Yen changing course and appreciated. It’s not a 2015 story but it is something to watch in 2016.”
The biggest risk Yakota identifies in the current Japan story is that Abe’s economic success can be reversed by his nationalism. “There is a consensus worry that Abenomics’ success and exit from deflation will allow Abe to change focus to his nationalistic agenda and in the future hurt Japan’s economy and equity performance. Abe’s deep desire is for Japan to play a bigger political role in the region and the world. He would need military capabilities to do that and as mentioned above, the first step is to change the constitution to grant Japan the power. In his current term as prime minister, he has taken a different approach to nationalism by first improving the economy, which will give him the political capital to change the constitution. The worry is that he will show his true colour once Japan exits deflation and devote much of his political capital in increasing regional and political influence and ignore the continuous structural reforms that the Japanese economy needs to stay out of deflation.”