- Japan’s economy is forecast to grow above trend in 2021, first as exports recover and then as distribution of the vaccine unleashes pent-up demand in services sector.
- Fiscal spending should help support shares; reducing carbon emissions and enhancing digitalisation are key parts of the spending.
- Company earnings look poised for recovery though valuations in some cyclical areas have already moved up. A selective approach will be needed.
Piya Sachdeva, Economist:
"Many countries will be envious of Japan’s handling of the coronavirus this year. Ultimately, this has been key to the economy being able to match and in some cases, outperform, its developed market peers. Though the resurgence of the virus is an immediate risk to growth, the distribution of a vaccine paves the way for strong growth in 2021.
"Our broader outlook for strong growth and low inflation in the world economy is an environment that has typically been good for cyclical assets like Japanese equities. With Prime Minister Suga reigniting the reform agenda, the stars may well be aligned for Japan in 2021."
Japan outperforming Europe in 2020
"The Japanese recovery continues to be fairly robust, predominately driven by the recovery in demand for exports. An improvement in exports has also supported the industrial sector and, more recently, there are signs that the economic recovery is broadening out to investment. Meanwhile, pent-up demand from households, who had restricted activity earlier on in the year, seems largely exhausted at this stage.
"For the year as a whole, the Japanese economy is set to shrink by 5.1% in 2020. Though this is more than the US (-3.6%), Japan is set to outperform the eurozone (-7.1%) and the UK (-11.3%). This is impressive given Japan started the year on a weak footing after the 2019 tax rise. Ultimately, this has been due to Japan being able keeping the virus relatively contained and therefore avoiding a strict lockdown."
Japan to grow above trend in 2021
"Looking ahead, as the recovery continues the pace of growth should naturally slow. In particular, as the recovery in global trade slows and imports recover, this should reduce the boost in growth from trade. However, the distribution of the vaccine – which we assume to be in the middle of next year - should pave the way for a strong second half of the year.
"A return to normal social behaviour will likely support the service sector as a second wave of pent-up demand is unleashed. Wider consumption should also be supported by an improvement in wages. Global trade should also improve as restrictions are lifted across the world. Along with an improvement in earnings and confidence, this should help support corporate investment. For the year as a whole, we expect Japan to grow by 2.9% - well above estimates of trend growth.
"Clearly, our assumption of sufficient immunity in the second half of the year is crucial to our outlook. Otherwise, the main risk to the outlook is near term restrictions on activity both at home and abroad, given the rise in Covid cases in Japan and the US. The recent suspension of the domestic travel subsidy programme, Go-To travel, shows the authorities taking a more cautious turn following the latest rise in cases."
Fiscal measures are promising
"The most recent fiscal package to be approved by the Cabinet should help accelerate the recovery and is particularly promising. Firstly, because of its size: 5.3% GDP in direct spending. Secondly – and perhaps more importantly for investors - because of the composition. A significant proportion of the spending will go towards enhancing digitalisation and software capability as well as reducing carbon emissions. Suga is clearly wasting no time in reigniting the reform agenda. Measures to enhance competitiveness should help improve long run growth."
Bank of Japan in perennial easing mode
"Inflation has dipped into the red this year due to a multitude of factors including lower demand, lower energy prices, subsidies on travel and 2019’s tax rise falling out of the comparison. Though energy inflation should be the main driver of higher inflation next year, we expect mild deflation to continue near term and inflation to turn positive again in the second half of 2021.
"Underlying inflationary pressures should remain weak because of spare capacity, but importantly we do not expect Japan to fall into a deflationary spiral.
"Concerns around inflation should leave the Bank of Japan (BoJ) in perennial easing mode. The balance sheet, which has most recently been boosted by more purchases of government bonds and loan programmes, should continue to rise. But we expect the loan programmes to end next year and for the BoJ to begin to taper its purchases of government bonds in the second half of next year - around the same time as the Federal Reserve. Financial conditions should remain easy as but this could potentially test the market’s reliance on liquidity."
Japan is leveraged to the economic cycle
"Stepping back, our economic outlook is for Japan to grow relatively fast compared its historical growth rates. However, its low rate of trend growth means that even though Japan has had a head start – so to speak –it will inevitably be caught by other developed markets whose domestic economies have the ability to grow faster.
"However, developments in the world economy have often been a more important driver for the Japanese equity market. Our global economic outlook for high growth and low inflation points to a strong environment for cyclical assets. Japan stands out as a highly cyclical market that is leveraged to the industrial cycle with economic momentum, easy liquidity conditions and ongoing reform."
Ken Maeda, Head of Japanese Equities:
"2020 has undoubtedly been a challenging year for Japan as the Covid-19 pandemic caused a huge disruption in both the economy and corporate earnings. The unexpected dislocation in equity markets in February and March has been followed by an equally surprising market recovery, which was already well underway before being boosted by news of successful vaccine developments.
"Japan’s equity market has been primarily influenced by global trends in 2020, although there have been some differences in market dynamics. Most markets saw consistent momentum in a relatively narrow range of stocks but this has persisted for longer in Japan, while other markets have seen a more marked style reversal in recent months."
Lower disruption from pandemic compared to other regions
"All the available data suggests that Japan has, so far, weathered the pandemic better than most developed economies. Restrictions on economic activity and mobility have generally been less severe. However, a recent pick-up in infections means it is still possible that we could see a state of emergency re-imposed in coming months, for the first time since May. Beyond this, of course, progress in vaccine deployment should give us some comfort for the outlook later in 2021.
"Japan has already placed firm orders with a range of different vaccine suppliers which, ultimately, will be sufficient to cover the whole population. Although regulatory filings have not yet been made, Japan should be in a position to roll out vaccines to healthcare professionals in the first quarter of 2021 and to the general population within the second quarter."
Olympics to have minimal market impact
"One Japan-specific event for 2021 will be the hosting of the delayed Tokyo Olympics. The current political view seems to favour a scaled-back version of the games, which would start in July.
"Although this will be a high-profile event, the real economic impact is likely to be negligible. Most of the impact will be seen in a far lower number of tourist arrivals than originally expected, but this has already been fully discounted by the equity market and we don’t see any great scope for surprise."
Elections due, but LDP to remain in power
"However, developments around both the Olympics and the vaccine roll-out could also affect the political timetable in Japan. Although the transfer of power from Mr Abe to Mr Suga has not led to any unexpected policy changes, a general election is due by October 2021 at the latest and it is still possible that we could see a snap election called earlier in the year. In any event, we expect the ruling Liberal Democratic Party to retain power, and for Mr Suga to remain as prime minister.
"The policy mix is therefore likely to remain supportive throughout 2021. Fiscal stimulus has been further extended in December by agreement on an additional supplementary budget, and fiscal policy will therefore remain expansionary over the next 12 months. Monetary policy will also remain very accommodative and we expect a continued focus on structural reforms and deregulation.
"Overall, we believe that the macroeconomic backdrop remains supportive for the Japanese equity market in 2021. In the short term, we need to monitor carefully the recent increase in Covid-19 infections and the impact of this on consumption, especially in service sectors."
Company profits poised for recovery
"In the absence of dramatic deterioration in economic conditions, we now see scope for a significant recovery in corporate earnings in fiscal year 2021, supported by the most recent corporate results for the June to September quarter. These showed a significant proportion of companies beating consensus estimates, led by the recovery in end-market demand together with solid discipline on cost control.
"The overall revision index has already turned positive which should bode well for corporate earnings prospects into 2021.
"While overall market valuations look reasonable, we do note that some cyclical stocks may already be discounting much of the initial expectations for earnings recovery. But, beyond these cyclical dynamics, we continue to see positive structural tailwinds supporting the Japanese equity market, including company-specific efforts to improve return on equity. Despite the challenging environment in 2020, Japanese companies are continuing to increase spending on IT and software, in particular, in order to improve future productivity."
Growing momentum behind ESG improvements
"In 2021 we also expect further positive momentum in corporate governance improvements. In addition to company-driven changes, and our engagement efforts with company managements, additional impetus is likely to come from the next scheduled revision to the Corporate Governance Code.
"Meanwhile, dividend payments have held up relatively well in 2020, as we had anticipated, given the financial strength of many Japanese companies. Inevitably we have seen some reductions in share buybacks but recent evidence suggests even these programmes are starting to revert to previous trends.
"In addition to governance improvements we also believe that the experience of 2020 will accelerate the influence of social and environmental factors in determining individual stock price levels. These combined issues of sustainability therefore remain at the heart of our research, both through our extensive company visit schedule and through our active engagement programmes."
Stock-specific focus remains crucial
"Overall, we remain constructive about Japanese equity market into 2021 as we are likely to see continuous earnings improvements. However, the recent recovery in share prices, driven by vaccine-related news flow and the conclusion of the US presidential election, has pushed overall market valuations to the higher side of their historical ranges.
"We therefore need to be selective in our research and stock selection, focusing primarily on companies whose management are taking decisive action towards a sustainable improvement in returns, while maintaining our valuation discipline."