Where next for Japan as election looms?
When we look at Japan, our current feeling is that 2017 is progressing largely as expected in terms of domestic policy and macroeconomic data. However, market sentiment has been held back by external events and, to some extent, by the domestic political uncertainty which has emerged recently.
As a result, we find a greater gap between our view and that which is discounted in market valuations. Hence, our degree of conviction in the potential market upside should therefore be increasing.
Data trending upwards
The most recent Japanese GDP data for the quarter to June was better than expected and there was also an upward revision to growth in the previous quarter. The June quarter marks the sixth consecutive quarterly growth in Japan’s GDP for the first time in more than 10 years.
Furthermore, the composition of growth clearly shows a lower dependence on external demand, with the domestic economy increasingly taking up the bulk of the heavy lifting, in particular corporate capital expenditure.
The main area in which our earlier view of Japan this year has not unfolded as planned is in domestic politics. As recently as early June, despite the emergence of a couple of relatively minor scandals, we were happy to say that we expected Prime Minister Shinzo Abe to easily retain the leadership of the Liberal Democratic Party (LDP) after his current term expires in September 2018.
We were also looking forward to a similarly predictable LDP victory against a weak and fragmented opposition, in the lower house elections due by December 2018 at the latest.
However, thanks to some inept handling of the scandals and a disastrous result for the LDP in the Tokyo local assembly elections, Mr Abe saw a dramatic fall in popular support, as shown in the chart below.
The most recent surveys do show a slight bounce following the cabinet reshuffle in early August but it is clear that Mr Abe has lost his previous aura of invincibility. Until three months ago, most observers would have struggled to name any potential successor, but now there is at least a name in the frame.
Despite Mr Abe’s short-term difficulties, it would be hard to imagine the Tokyo assembly result being replicated at the national level. This may be tested sooner than we expected as a snap election has been called in October.
We may also see Mr Abe looking to rebuild his authority by re-focusing on economic policy with fewer distractions from his attempts to amend the constitution. With this may come a renewed emphasis on expansionary fiscal policy.
A static central bank
Meanwhile, the other pillar of economic policy has produced no surprises as the Bank of Japan (BoJ) has made no changes to its aggressive stance.
Indeed, while other central banks have been preparing markets for an eventual policy withdrawal, the BoJ remains alone in signaling that it is prepared to maintain current policies until inflation overshoots its own ambitious target of 2%.
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 0%.
In recent months this target has been achieved relatively easily and with the US Federal Reserve managing expectations successfully, we should expect little stress in the Japanese Government Bond (JGB) market in the next couple of quarters.
Despite this relative calm, we are keenly aware that current monetary policy is unsustainable over the longer term. Although not explicitly stated as such, even the central bank’s stated 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 current yields necessitates a lower run-rate of JGB purchases, which is already beginning to show up in the data, as shown below.
The Bank also continues to be an active buyer of Exchange-Traded Funds (ETFs) in the equity market. Although this may be an effective part of the asset purchase programme, it also carries overtones of market support which doesn’t appear strictly necessary.
And despite foreigners appearing to remain sceptical of the equity market, it seems clear that the performance of corporate Japan is improving under the current economic conditions.
Improvement in corporate fundamentals
Clear evidence of an improvement for Japan Inc. was seen in the results for the fiscal year to March 2017 and again in the results for the quarter to June.
The majority of companies produced positive earnings surprises for this period compared to the consensus and a much higher proportion than usual were prepared to revise up their full fiscal year numbers based on this one quarter.
This has reinforced our belief that initial estimates were overly conservative and has set up the prospect of a strong upward revision cycle for corporate profits. As profit growth continues, the profit share of GDP continues to expand, emphasising the growing disparity with labour incomes.
Virtually every piece of economic data, except individuals’ inflationary expectations, is pointing towards higher wage growth but this has still been much slower to materialise than we would have expected.
Although no-one should be surprised by the strength of labour market, it is worth reiterating that the economy is running very close to full employment, with an unemployment rate of just 2.8%, the lowest level seen for more than 20 years.
Furthermore, while Japan’s total population has already peaked, it would be wrong to attribute the current tightness in the labour market to demographics alone. In fact, Japan’s labour force has been growing for several consecutive years, but job creation has been growing even faster.
The most recent data from the last few months suggest that more of these new jobs are now being generated in full-time occupations – adding to the upward pressure building for wage growth.
The evidence from the BoJ’s quarterly Tankan survey also clearly indicates growing confidence among Japanese corporates. Perhaps most importantly, the aggregate survey responses now indicate capacity shortages 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.
An uncertain world
While the domestic economy continues to head in largely the right direction, the risks to our view remain mostly external. Early in the year, Japan had become more confident after building relationships early with the Trump administration but some of the risk associated with 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.
Rather obviously, 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 in to equity portfolios.
Although the US has suddenly awoken to the possibility of being within range of North Korea’s missiles, Japan has been within range of even basic rocket technology for many years already.
What has changed, of course, is the level of rhetoric and the apparent willingness of the US to indulge in threats and counter-threats which has made the ultimate end-game more uncertain.
How does the yen look?
Such external or geopolitical risks typically lead to a stronger yen than we might otherwise expect, reflecting the currency’s ‘safe-haven’ status.
While we don’t believe that current levels of the yen pose any threat to our economic or corporate expectations, the equity market has continued to show a very tight negative correlation with the currency (meaning that the market typically declines as the currency appreciates).
Intriguingly, this negative correlation has recently weakened, as shown in the graph below. While we would view this as positive, it is far too early to identify any trend as similar reversals into negative correlation have been seen a handful of times in the last 10 years.
If we extend this chart back a further 10 years, as shown below, a fascinating picture emerges. Up until 2007, the Japanese market habitually showed a positive correlation with the currency – meaning that both the market and the currency typically appreciated at the same time.
Many members of our Japanese equities team have experience of both of these environments, and we see no particular reason why the most recent period of negative correlation should be regarded as the norm.
Where to from here?
As Japan grinds its way out of deflation we believe that the operational gearing of Japanese companies will continue to provide positive surprises, in the sense that relatively small improvements in economic conditions lead to larger changes in the aggregate level of profits.
While this trend has already been evident in the last two quarters, Japan’s equity market has underperformed other developed markets in this period.
Relative valuations have therefore moved in Japan’s favour at a time when confidence in the profit outlook should be increasing. This apparent anomaly could be corrected in the coming quarters as investors begin to reassess the profit potential for the world’s third-largest economy.
Watch Nathan Gibbs, Client Portfolio Manager, Japanese Equities, discuss the outlook for the Japanese market here.
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