Outlook 2023, Japanese equities: re-opening to provide boost

Japan enters 2023 as a clear outlier among developed markets in terms of the outlook for economic growth, monetary policy and inflation. With the domestic economy finally reopening, we see many companies well-positioned to continue to grow profits in the coming year.

After decades of deflation the Bank of Japan may be the one major central bank that is happy to see some external upward pressure on inflation from energy prices and the sharp weakening of the yen.

Even though these factors could gradually fade from the year-on-year inflation rate going into 2023, Japan does seem to be heading into a period of moderate and sustainable positive inflation. While producer prices have been rising for some time, we have recently seen more evidence of companies looking to pass on these increases to end-product prices, despite consumers remaining very price-sensitive after two decades of deflation.

Domestic recovery to come through at last

While a global recession is now looking increasingly likely, Japan is at a different stage of its economic cycle and there is potential for GDP to continue to grow above its long-term trend rate in 2023.

This represents a positive change as, compared to expectations at the beginning of 2022, it is clear that Japan’s domestic economic recovery has been slower than predicted so far. There are some external factors behind this, including the Shanghai lockdowns, but consumption and mobility data have also weakened around each wave of Covid infections in Japan. This is in spite of consistently lower overall infection and mortality rates than other developed countries.

Regardless of these successive delays in Japan’s domestic economic recovery, and heightened global uncertainty, Japanese corporations appear to be performing well and quarterly results announced during 2022 have been consistently ahead of expectations.

This has been particularly true for Japan’s manufacturing base, which has benefitted directly from the post-Covid global recovery and the weak yen. Non-manufacturing and service sector profits have also held up well, despite the extended restrictions imposed on domestic activity for much of this period.

We are now looking for further improvements in service and consumer-related areas which will be supported by the reopening of the domestic economy. The Japanese government has now been able to remove all Covid restrictions, including those on international travel from 11 October, which should provide a useful stimulus for the domestic economy going into 2023.

However, we still need to watch carefully any future pick-ups in Covid infections, as the high level of risk aversion in Japan could still dictate a more cautious reaction than that seen in Europe.

Fiscal policy to ease rising living costs

The ruling Liberal Democratic Party performed well in July’s Upper House elections, in the immediate aftermath of the shocking assassination of former prime minister, Mr Abe. This initially seemed to have reinforced the position of current prime minister Mr Kishida, but his public approval rating has recently come under pressure, as a result of internal party issues together with the potential for further increases in living costs.

Japanese consumers’ distaste for rising prices, after such a long period of deflation, has also led to some policy contradictions. The government has applied populist measures, including a range of subsidies and regulatory controls on energy prices.

A significant additional fiscal package, which is expected to be passed before the end of 2022, is designed to support the nascent recovery of the domestic economy. It also includes further specific measures that will exert downward pressure on consumer price inflation early in 2023.

By preventing headline inflation from rising more significantly above the Bank of Japan’s target, the government may also effectively delay any potential change in monetary policy.

Interest rates, not intervention, to dictate value of yen

In the meantime, successive rises in US rates, coupled with no change in Japan policy, has led to a widening interest rate differential between the US and Japan. This has been a significant factor in the consistent weakening of the yen in 2022.

This trend had accelerated in August and early September, prompting several public statements from the government, but the Bank of Japan’s room for manoeuvre on the exchange rate, in reality, has always been very limited.

In contrast, from late September onwards, the Ministry of Finance has been seen intervening directly in currency markets, especially when the yen has depreciated rapidly intra-day. These moves have been the first such direct intervention in support of the yen since 1998.

Even though Japan also has ample near-cash reserves in foreign securities, any such action taken by Japan in isolation can only yield short-term results. It is unlikely to create any long-term trend change in the absence of expectations for a fundamental shift in policy from the Bank of Japan.

Looking further ahead, equity investors will need to take on board the upcoming change in governor at the Bank of Japan as Mr Kuroda’s term comes to an end in March 2023. With Mr Kuroda so closely associated with the current policy of yield curve control, it is hard to envisage any substantive changes in the near-term. (Yield curve control involves the central bank buying bonds in order to keep the 10-year government bond yield close to 0%).

Nevertheless, over the next few months, we may see technical changes in the way the policy is implemented, which could indicate more clearly the direction of travel likely to be seen under his successor.

Corporate governance progress adding value

Our positive view on Japan is also supported by the ongoing improvements in corporate governance and the scope for this to generate real value for investors.

This is partly a qualitative assessment through our discussions with company managements, but there are also measurable impacts. These include improving Return on Equity and a record level of share buybacks announced in the current fiscal year.

These factors improve potential returns for investors. These, plus the ongoing revisions to the Corporate Governance code, together with improving disclosure on sustainability issues, will allow us to continue to generate individual stock ideas across the market cap spectrum.