Outlook 2018: Japanese equities

Japan’s domestic policy and macroeconomic data progressed largely as expected in 2017, but external events weighed on market sentiment for much of the year.

Positive signs build

The most recent Japanese GDP data for the quarter to September marked the first time in more than 15 years that the country’s economy has grown for seven consecutive quarters.

The evidence from the Bank of Japan’s latest quarterly Tankan survey also clearly indicates growing confidence among Japanese companies. Perhaps most intriguingly, the aggregate survey responses now indicate capacity shortage across all industries. This is a meaningful change from the excess capacity situation the economy has faced for almost all of the last 25 years and should bode well for capital expenditure into 2018.

Meanwhile, Japan continues to run very close to full employment, with the unemployment rate dropping to just 2.8%, the lowest level seen for more than 20 years.

Despite this, wage growth has still been much slower to materialise than we would have expected, even though virtually every piece of economic data, with the exception of individuals’ inflationary expectations, is pointing towards higher wages. With robust corporate profit growth continuing, the profit share of GDP has reached record levels, emphasising the growing disparity with labour incomes.

Monetary policy: unsustainable?

The Bank of Japan (BoJ) made no changes to monetary policy this year. Since September 2016, in addition to the asset purchase programmes, Governor Kuroda has operated a policy of yield curve control aimed at maintaining 10-year yields around zero percent. In recent months this target has been achieved relatively easily and, with the Federal Reserve successfully managing expectations in the US, we should expect relatively little stress in the Japanese government bond (JGB) market going into 2018.

Despite this relative calm, we are keenly aware that Japan’s current monetary policy is unsustainable over the long term. Although not explicitly stated as such, even some of the central bank’s own aims conflict with each other.

The combination of a fixed amount of JGB purchases together with the yield curve control implies an attempt to target both volume and price simultaneously.  In fact, the maintenance of the current yield target necessitates a lower volume of JGB purchases, which is already beginning to show up in the data.

The BoJ also continues to be an active buyer of ETFs in the equity market. Although this may be an effective part of the asset purchase programme, it also carries overtones of a market support mechanism which doesn’t appear strictly necessary.

Investor scepticism

Until late September of 2017 foreigner investors remained sceptical of the equity market. This was despite clear evidence that the performance of corporate Japan was improving under the current economic conditions.

This has become particularly apparent in the results released for both the June and September quarters. The majority of companies produced positive earnings surprises for this period compared to the consensus and a much higher proportion than usual have been prepared to revise up their full-year numbers early in the fiscal year.

This reinforced our belief that initial estimates were overly conservative and has generated a strong upward revision cycle for corporate profits. Although some of this profit growth has been discounted in share prices during the recent rally, overall market valuations are still attractive relative to their own history and compared to other global markets.

External risks linger

While the domestic economy continues to head in broadly the right direction, the risks to our view remain largely external.

Although Japan was successful in building relationships early with the Trump administration, the risk of increased US protectionism and trade retaliation still exists. This could easily return to the political agenda if the US administration continues to struggle to deliver on other elements of its growth strategy.

In addition to these concerns, North Korea has recently dominated the list of potential risks for Japan. Although hugely significant, the binary nature of the possible outcomes makes it impossible to effectively price-in this risk to equity portfolios.

Abe’s domestic success

The main domestic surprise of 2017 was Prime Minister Abe’s call for a snap lower house election in October. After considerable initial uncertainty over the potential election outcomes, the likelihood of an LDP victory increased steadily in early October, enabling equity investors to form a view on the likely continuation of both monetary and fiscal policies. This more stable sentiment was matched by a significant pick-up in net purchases of Japanese equities by foreign investors which helped to push the market to 26-year highs.

Although the combined number of seats for the LDP and Komeito is marginally lower than their previous total, the coalition has retained its important two-thirds majority.

Given the uncertainty which existed earlier in October, this should be seen as a significant success for Mr Abe. We would now expect him to be re-elected as leader of the LDP in September 2018 and therefore remain as Prime Minister beyond the 2020 Olympics, if he wishes to do so.

The election result also effectively reduces the uncertainty around the position of the Governor of the Bank of Japan, Mr Kuroda, whose current term expires in April 2018.

Economy to return to the fore

Given the brief period of popularity enjoyed by some opposition parties at the beginning of the campaign, we might now expect a renewed focus on economic measures as Mr Abe embarks on his new term.

We should certainly anticipate a continuation of aggressive monetary and fiscal policies which are very supportive for the Japanese equity market. A further slight acceleration in fiscal spending may also be possible as an offset to the planned increase in consumption tax which is scheduled by Mr Abe for October 2019.

Corporate comfort?

This policy environment should provide favourable conditions for continued solid growth in corporate profits in 2018.

Companies are gradually regaining some ability to raise prices and this should feed through directly to higher profits as the operational gearing of companies is high after a long period of deflation.

Of course, we need to be alert to the prospect of higher wage costs which could impact some companies negatively but, in aggregate, these macro trends simply represent a normalisation of Japan’s economy and should be positive overall for sentiment.

Other articles in our Outlooks 2018 series are available here.