Japan’s Pro-Growth Agenda: How “Abe-ism” Will Reignite Abenomics

Japan

After a period of relative calm and no new initiatives, Japanese politics is likely to move back into global headlines in the coming months. This is because Prime Minister Shinzo Abe has now presented a concrete timeline for reforming Japan’s constitution: the goal is to clear all the necessary parliamentary hurdles by the summer of 2018 so that the required national referendum can be called before the end of that year. This ambitious agenda will not only push Japan back into global headlines but will reignite Japan’s pro-growth policies into 2018 and 2019. In our view, a “double election”—lower house and constitutional referendum—seems likely in autumn 2018, ushered in by added easing of fiscal policy in general, postponing the next tax hike, as well as greater Bank of Japan (BoJ) commitment to push real rates down to at least negative 2%.

From Abenomics to “Abe-ism”: Interdependent Policy Activism

Both at home and abroad, Abe’s newfound urgency to press for constitutional reform is likely to raise worries. Is Abenomics morphing into “Abe-ism”—that is, will political capital now be squandered on a nationalist agenda rather than economic reform?

Personally, I am not worried about an either/or situation. Yes, there can be no doubt about the deep-rooted patriotic agenda driving “Team Abe”; however, this agenda is pragmatic and Machiavellian, inspired by the “Fukoku Kyohei—Strong Country, Strong Army” philosophy embraced by the samurai leaders who led Japan’s modernization and reform in the late 19th century.

Clear speak: Yes, Abe’s principal goal is to secure Japan’s undisputed status as a tier-one nation, but to get there, Japan must have a top-tier economy. Just as the Meiji reformers did more than one century ago, Team Abe knows that, to be taken seriously by the two big global powers—China and America—Japan’s corporate, financial and human capital must be restructured to generate performance levels envied by the world. Team Abe is convinced that without successful Abenomics, Abe-ism is doomed to fail.

More to the point, Abe’s timeline on constitutional reform hints at the coming positive feedback between national agenda and pro-growth economic policy. Not only can we safely rule out a premature policy tightening, but now the probability of added policy easing has risen. The more ambitious the constitutional agenda, the greater the imperative to create a stronger “feel-good” factor for the voting public.

Power Politics with Options

It is no coincidence that Abe’s “constitution referendum by the end of 2018” goal is in total sync with the most important macro policy decision facing Japan: by the end of next year, the government will have to decide whether the next consumption tax hike will  go ahead. It is currently scheduled for October 2019, but the final decision will only be made in the 2019 draft budget debate, due to be completed by December 2018. Machiavellian bonus: Abe must call the next general election by the same December 2018.

Practically speaking, the threat of election will keep his Liberal Democratic Party in line, and the tax hike decision creates options. Empirically, tax hikes are three-for-three triggering economic downturns, which is why Team Abe forced a postponement of one in early-2016. Standing up against the powerful bureaucracy and its tax-hike lobby was a key factor securing his landslide victory in the upper house election a couple of months later. A repeat performance is likely, in our view—postpone the unpopular tax hike as a bargaining chip for the controversial constitutional reform.

Fiscal Dominance = No Urgency for Hike Taxes

Here, it is important to note that Japan’s current monetary policy regime has reduced the urgency of fiscal consolidation. The BoJ now explicitly guarantees zero-rate funding costs for treasury debt and promises to keep this anchor until inflation exceeds 2%. Real 10-year bond yields are poised to drop by at least 150 basis points (bps), which in turn could cut real interest expense by as much as ¥15 trillion. With total consumption tax revenues at just above ¥17 trillion,1 fiscally conservative economists will be hard-pressed to convince Team Abe that they should risk an almost certain recession (by hiking the tax) against an almost certain “free ride”—provided the BoJ holds its course. A guarantee to stay the course would appear to be the minimum necessary job requirement for Abe’s choice as the next BoJ governor (Governor Haruhiko Kuroda’s first term ends April 2018).

Market Implication: Higher Risk, Higher Return

All said, a double election—lower house and constitutional referendum—coming in the autumn of 2018 looks like a reasonable assumption. This should be good news for Japanese risk assets, if we are right and the coming pickup in Japan’s political metabolism results in a revival of pro-growth policies.

Two important triggers: first, evidence of easier fiscal policy coming into 2018/2019; and second, rising evidence that the BoJ will hold on to its current target of pushing real rates to at least negative 2%. Easier fiscal policy plus easier monetary policy should result in both a weaker yen and a rising equity market.

While economists may describe Japan as “Fiscal Dominance,” “Political Dominance” may be a more appropriate description for what lies ahead for Japan over the coming 12 to 18 months. The fact that both the constitutional and the economic agenda are controversial and unprecedented raises risks in Japan—and thus potential returns.

In our view, Abe’s ambitious constitutional agenda (Abe-ism) – is making the success of Abenomics more likely.

1Japan Ministry of Finance, April 2017.

Jesper Koll is the Head of Japan at WisdomTree Investments.

 

Important Risks Related to this Article

Investments focused in Japan increase the impact of events and developments associated with the region, which can adversely affect performance.

Stocks and Bonds: Two Markets Telling Different Tales

Compass

In the months following the 2016 US presidential election, US stock and bond markets moved inversely, both anticipating a pickup in economic growth. Equities rose smartly while bond prices fell, pushing yields higher, anticipating that faster growth would eventually lead to an uptick in inflation. But in the last few months, the stock and bond markets have begun to tell very different tales. Stocks have moved up unblinkingly, and bond prices have moved up as well, driving yields lower. The bond market is telling a story of lower growth and lower inflation ahead. But no one’s told this slowdown story to the stock market. It assumes nothing has changed.

The reflationary expectations that helped set stocks alight and send interest rates higher last fall have subsided significantly. In particular, hopes for a stimulative policy mix from Washington have faded as Congress and the White House find themselves sidetracked by scandals. Despite those waning hopes, equity markets have extended their advance, setting multiple record highs along the way. However, US 10-year Treasury note yields have fallen roughly a half-percentage point from their post-election highs. Why are markets telling two different tales? Let’s try and figure out which one is right.

Market’s narrow focus a worry

While I mainly focus on fundamentals like earnings growth and free cash flow generation, at times I find it useful to also take a look at technical factors. And the technical that jumps out most clearly to me at the moment is the narrow breadth in recent months of the market’s latest rally. That advance has been largely fueled by a handful of glamorous, well-known, mega-capitalization technology companies. Indeed, a recent sell-side analysis shows that nearly 40% of this year’s gain in the S&P 500 Index can be linked to just four stocks. Narrow advances have historically tended to be a warning sign. Looking back at similar periods in history, we see periods where, when just a few names led the market, outcomes tended to be less favorable than when market breadth was broad, such as earlier in this business cycle, when many stocks in the major averages were supported by record levels of free cash flow. As a technical matter, bad breadth is a cautionary sign.

Bond bull still breathing?

Long-term interest rates have been trending lower for more than three decades, but somewhat of a cottage industry has developed around predicting the bull market’s demise. And those calls reached a crescendo shortly after the election, predicated on inflation’s return, fueled by a synchronized upturn in global economic growth, low levels of unemployment and a stimulative policy mix from Washington. But markets have reassessed that call in recent weeks, sending Treasury yields lower on the back of dimming prospects for tax cuts and infrastructure spending, sluggish US growth and few signs that tight labor markets are leading to above-trend wage gains. In essence, the bond market may be trying to tell us that slower growth lies ahead.

So which market is right? While it is far too early to forecast that a recession lies ahead, forward indicators suggest we may see a mini down cycle in the not-too-distant future, not dissimilar to the three or four dips we’ve seen within the present eight-year expansion. To me, this suggests investors may want to be cautious in putting new money to work in “risky” assets such as equities and high-yield bonds.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.

 

Past performance is no guarantee of future results.

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What’s Behind the Tech Selloff

A stack of table and chairs in a pale blue room

On the surface things appear calm. The S&P 500 remains within 1% of its all-time high and volatility is still barely half the long-term average. However, under the surface things may be starting to churn.

Since last Friday tech stocks have been sold hard, with few obvious catalysts. For example, at the lows on Monday Netflix (NFLX) was down over 10% and Apple (AAPL) off 8%. What is going on?

1. An abrupt reversal of this year’s momentum trade.

In a throwback to the late 1990s, tech has once again become a momentum play. The reversal in tech is part of a broader reversal in momentum stocks, a style in which tech features prominently. Using the MSCI USA Momentum Index as a reference point, it is instructive that Microsoft (MSFT) is the biggest name, with a 5% weight. At the industry level, semiconductors, software and computers represent three of the top four industries.

2. Multiples are much higher.

Bulls can rightly point out that tech valuations pale in comparison to the surreal levels of the late ’90s. Still, multiples have been rising fast. The trailing price-to-earnings (P/E) for the S&P 500 tech sector is up over 35% from last year’s low. At nearly 25x trailing earnings, the sector is the most expensive it has been since the aftermath of the financial crisis, when earnings were depressed. On a price-to-book (P/B) basis, valuations are even more extended. Large cap U.S. technology companies are trading at the highest level since late 2007.

3. The surge in growth has made the entire style expensive.

The surge and recent drop in technology needs to be viewed through a prism, which is: As investors have reconsidered the “Trump trade,” they have reverted to two investment themes–yield and growth. This has left U.S. growth stocks very expensive compared to value stocks. While tech valuations may not be in bubble territory, the ratio of value to growth multiples is starting to bear an eerie resemblance to the late 1990s. As of the end of May, the ratio—based on P/B—was just below 0.33. This is roughly 1.5 standard deviations below average and close to the all-time low of 0.31 reached in February of 2000, right before the tech bubble burst.

Growth vs Value

In some ways, the recent selloff resembles the “quant crash” of 2007. Similar to today, levered funds were seeking to juice returns in a low volatility world while crowding into momentum names. Whether the current disruption is eventually viewed as the first crack in the edifice, as was the case in ’07, or just a temporarily blip in a long-running bull market, remains to be seen. What is clear is that the narrow pursuit of a few story stocks has left the market more fragile than top-line indicators would suggest.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

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Thoughts on U.S. Market Valuations

Dividend Payout Ratio

At the Chartered Financial Analyst (CFA) Institute Annual Conference in Philadelphia last month, there were a number of conversations with dour outlooks for the future of U.S. equity markets. The center stage of the conference featured a debate between Yale Professor Robert Shiller, designer of the CAPE (cyclically adjust price-to-earnings) ratio, versus my mentor, Professor Jeremy Siegel.

Shiller has a more subdued outlook for future returns than Siegel, who is a bit more optimistic. Jack Bogle also presented at the conference and suggested we’ve seen strong gains in the markets over the last 35 years that resulted from valuation expansion, and hence also had a more subdued outlook. Bogle’s model was fairly simple: take the 2% dividend yield on the market today, add in his personal estimates of 4% earnings growth, and subtract 2% from speculative market activity or his anticipation of a decline in valuation ratios over the coming decade, and you come up with an outlook for 4% returns over the coming decade. If we assume there is 2% inflation, this would lead to just a 2% real return after inflation. Note that this is largely similar to Shiller’s outlook for returns.

One chart that I think is not talked about enough in the context of valuation changes on the market is the dividend payout ratio of the market. I show a smoothed 10-year average dividend payout ratio in the spirit of Shiller’s 10-year smoothed earnings for the CAPE ratio. Prior to 2000, the dividend payout ratio averaged 60%. Since 2000, the dividend payout ratio has averaged 40%. This change in the nature of how firms reinvest their earnings, conduct stock buybacks, and pay dividends is absolutely critical to the future earnings growth we are likely to get.

CAPE EPS Growth Rate

Those who assume that earnings growth rates will revert to some historical average growth rate when firms paid out 60% of their earnings as dividends are assuming that all this money not being paid out—used for either buybacks or other reinvestment in business—is being completely wasted. That is an incorrect assumption, in my view.

This chart looks at the rolling 10-year and 20-year earnings growth rates of the CAPE earnings per share (EPS) that Bob Shiller uses to make his dour forecasts on the market. If these numbers were to “mean revert,” that would be a cautionary tale for the markets. But in my view, the earlier declining dividend payout ratio means we are likely to see upside changes to these earnings figures. What is possible?

Changing dividend payout ratios have already translated to better earnings growth. Prior to 1982, the average dividend yield on the U.S. equity market was approximately 5% per Shiller’s data, and we had an average dividend payout rate of nearly two-thirds of earnings paid out as dividends. With only a third of earnings reinvested, firms were still able to achieve earnings growth of 3.3% per year.

Shiller Data

Since 1982, payout ratios declined to an average of 51.1%, while at the same time firms started conducting stock buybacks. The average EPS growth during this period of reducing dividend payout ratios was an increase of 160 basis points (bps) per year, from the previous long-term average of 3.3% per year to 4.9% per year.

When we look at the last 20 years, and particularly the last seven, we see consistent signs of 2% dividend yields with 2% net buyback ratios. These net buybacks are going to continue to support earnings growth for the 10-year look-ahead period. These firms have locked in future EPS growth because they reduced their shares outstanding.

Returning to the table above, where I showed the earnings growth since 1982 as being higher than the previous 110 years, the current dividend payout ratios are consistent with an even further drop in the payout ratios from their average since 1982. I can see a case that earnings growth picks up even from that 4.9%-per-year mark that we had for the period 1982–2016. It would not surprise me to see earnings growth of 6% to 7% per year over the next decade.

Dividends Buybacks

The standard pushback is that firms are just leveraging up to conduct buybacks—that interest rates are at historical lows, leading to higher margins than are sustainable. The reverse case is that the changing composition of companies—into higher-margin businesses that have more revenue abroad with lower tax rates than in the U.S.—also means margins may not be mean reverting anytime soon either. Of course, no one knows how the future will unfold, including me.

The charts above caution anyone relying on historical patterns of earnings growth trends from overextrapolating them into the future. Professor Siegel looks at the current earnings yield of the market associated with a 20 price/earnings ratio and thinks 5% is a pretty good indicator of long-term, after-inflation real returns. Add in inflation of 2% and you get 7% nominal returns. This is a touch below their historical 6.5% to 7% that he showed in Stocks for the Long Run as being the historical return to U.S. equities, but it is not dramatically different. I think his model for looking at the markets makes more sense than some of these more dour predictions—for what that’s worth.

Jeremy Schwartz is the Director of Research at WisdomTree Investments.

 

Important Risks Related to this Article

Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time.

Is the “Trump Trade” Finished?

While dramatic turns and surprises may make for great reality television and may be very helpful for media ratings, they are less than ideal in the markets. We’re now getting a lot of bombshells out of Washington, D.C., and it is becoming increasingly difficult to think that the pro-growth policies and “Trump agenda” are not at risk.

Year-to-Date Reversals1

Trump Reflation Trade 2017

  • The Russell 2000 Index was a rather dramatic market signal that showcased a strong response to President Trump’s November 8, 2016, victory, and there were a number of supportive catalysts for U.S. small-cap stocks after the election and at the end of the year. Rising rates—specifically, a rising U.S. 10-Year Treasury note yield—were driven by increasing growth expectations, something typically quite bullish for small-cap stocks. Additionally, corporate tax reform was seen as very possible given Republican majorities in both the U.S. House of Representatives and the Senate, and small-cap stocks tend to pay higher effective tax rates than large-cap stocks, thereby benefiting more from lower statutory rates. Also, the Bloomberg Dollar Index—a measure of the performance of the U.S. dollar against a diversified basket of currencies—was up 5.7% from November 8, 2016, to December 31, 2016. Since small caps derive the vast majority of their revenues from inside the U.S. rather than outside, this was yet another reason why the Russell 2000 Index did so well. In fact, there were 15 days in a row of positive gains on this index, the longest such streak since 1996.2

As of this writing (June 2, 2017):

  • The U.S. 10-Year Treasury note interest rate has fallen since the start of 2017 from 2.44% to 2.15%.
  • The Bloomberg Dollar Index is down 5.8%.
  • With each passing week, it is looking more and more challenging for corporate tax reform to be completed in 2017.

So the Russell 2000 Index—the performance of which was one of the strongest symbols of the “Trump trade”—has faltered.

You Need to Take Risk to Put Yourself in the Way of Potential Rewards

It’s clear that, in the initial euphoria of President Trump’s victory, many international markets didn’t participate—and there wasn’t any strong reason why they should have. The Russell 2000 Index exemplified the “sentiment flows.”

For example, the specter of political risk in Europe was hanging over developed international markets. Even though for years we had been discussing the story supportive of developed international equities, it seemed like there was always a reason why the more expensive U.S. market was perceived to be less risky going forward. In other words, the higher multiples/valuations were “worth it” because the view of the market was that the rest of the world was riskier.

Now that we’re coming into the summer of 2017, we can see that those courageous and able to look beyond the apparent U.S. luster in the aftermath of President Trump’s victory—investing beyond U.S. borders even in the face of the perceived risks—have largely outperformed those who stuck with their home bias.

Not All Small-Cap Stocks Are in the U.S.

It seems like an obvious truth—and it’s noteworthy that the MSCI ACWI Small Cap Index is only 51% weighted to the U.S.3—but many investors that we speak to do all sorts of differentiated U.S. equity strategies and then simply “buy the benchmark” for their international exposures. For many, international small caps represent a new piece to their asset allocation puzzle.

Outperformance AND Lower Current Valuation

The MSCI EAFE Index is the most widely followed developed international benchmark that we tend to see in our discussions—and it has been doing well this year. But the WisdomTree International SmallCap Dividend Index has beaten it.

Small Cap Valuation

For those investors who believe that the Trump agenda may be in trouble, why would they contemplate buying into (or holding) a market cap-weighted approach to U.S. small caps, such as the Russell 2000 Index, with a forward P/E ratio of nearly 29.0x? Developed international small caps are certainly not without risk—but at a forward P/E of approximately half as much, it’s possible that a lot of that risk has been priced in.

Align with the Momentum of the Summer

While these things are never certain, relative to where we were at the start of 2017, developed international markets are tending to shift from more negative to positive expectations. U.S. expectations were very positive and may be shifting to become more negative. Tapping into this shift with developed international small caps could bring helpful diversification into one’s small-cap allocation.

 

1Unless otherwise noted, Bloomberg is the data source for all bullet points.

2Source: Lu Wang Lu, “U.S. Stocks Rise to Record as Trump Rally goes on for Third Week,” Bloomberg Markets, 11/25/16.

3Source: Bloomberg, with data as of 4/30/17, due to availability of monthly constituent data for MSCI indexes.

 

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.

Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development.

Diversification does not eliminate the risk of experiencing investment losses.