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.

3 Telltale Signs the Japan Rally May Not Be Over

Asian sushi chopsticks, rose tea and teapot over stone table. Top view with copy space; Shutterstock ID 350839565

Last year, the markets were distinguished by a lack of persistence. In many respects, investor behavior in the second half of the year was the mirror image of the first six months. However, one element remained consistent, at least among U.S. investors: a preference for domestic over international equities.

With U.S. stocks having a strong start to 2017, many are likely to remain committed to a big home country bias. I think this is a mistake. As I discussed last fall, relative performance is starting to shift. Since last summer’s lows, Japanese equites are up roughly 25% in local currency terms. Europe is up over 20% (gains are lower in dollar terms). Going forward, I still believe that Japanese stocks in particular merit a larger allocation.

Japan still the cheapest developed market

While Japanese stocks bottomed in 2012, Japan remains reasonably priced in contrast to the U.S., just about every other developed market and even many of the emerging markets in Asia (see the accompanying chart). Other markets, notably the United States, have seen prices driven primarily by multiple expansion, i.e. paying more for a dollar of earnings, though Japan has benefited from rising earnings.

BlackRock Valuation Chart

Supportive monetary policy and rising inflation

Headline inflation (measured by the Consumer Price Index) in Japan is rising at the fastest pace since early 2015. Not only is this good news for a country long mired in deflation, it is particularly important in the context of the Bank of Japan’s commitment to keeping interest rates close to zero. To the extent inflation continues to rise, real interest rates (the interest rate after inflation) move deeper into negative territory, suggesting ultra-accommodative monetary conditions and a weaker yen. The latter is key for an economy geared toward global trade.

An improving corporate sector

Historically, one of the many challenges facing Japan was a relatively unprofitable corporate sector. That is in the process of changing. Improving corporate governance coupled with Japan’s own buyback trend has pushed the notoriously low return-on-equity (ROE) up to around 7%. While still low by U.S. standards—partly a reflection of a multi-decade deleveraging by Japanese corporations—this is well above the 20-year average of 4%.

For U.S. investors, it is instructive to compare the bull market gains in the United States to those in Japan. Here in the U.S., the price-to-earnings (P/E) ratio on the S&P 500 Index has risen by roughly 75% since market bottomed in 2009. In contrast, since bottoming in 2012 Japanese equity valuations are relatively flat. As a result, Japan remains a value play in an increasingly expensive world.

To be sure, there are risks. First and foremost, a thriving Japanese stock market is most likely predicated on a weaker yen. This suggests that dollar-based investors will want to at least partially hedge their foreign currency exposure.

Still, investing outside the U.S. may not seem obvious in the midst of a still strong U.S. bull market; perhaps that is exactly the time when investors should seek more diversification.

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. Past performance is no guarantee of future results. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of January 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

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The Big Trends in the Global Economy

Global Growth

A lot has seemingly happened in the global economy in recent months, from a plunge in the oil price to a surge in the value of the US dollar against foreign currencies to an election in Greece that led to renewed fears about the possibility that the euro zone would break apart. But what’s been the upshot of all these changes? The latest World Economic Outlook report from the International Monetary Fund provides some data to answer that question.

According to the IMF’s report, the global economy is expected to grow by 3.5% this year. That’s lower than the projection of 3.8% growth that the IMF made six months ago. The change is largely the result of slower expected growth from emerging markets (5.0% six months ago versus 4.3% now). The prospects for developed economies, on the other hand, have actually improved slightly. While the estimated 2015 growth for the US hasn’t changed (it’s still 3.1%), the IMF boosted its growth estimates for the euro area and Japan.

Even though expectations have declined for emerging economies as a whole, not every country has a similar story. Six months ago the IMF expected a positive growth rate this year in Russia and Brazil; now it expects both countries’ economies to get smaller. The anticipated growth rate for China has also declined, although it’s still very high at 6.8%. India has gone in the other direction. Six months ago the IMF was projecting that India’s growth this year would be 6.4%. The latest estimate is 7.5%.

It’s important to remember that there’s only a weak link between economic growth and stock market performance, so simply buying stocks of fast-growing countries (or stocks of countries where the economic outlook has improved) probably isn’t a good idea. In fact, China and Russia have been among the best-performing stock markets so far this year. Still, thinking about the global economy in terms of these numbers may make the big-picture trends more apparent.

The Latest Twists and Turns in Japan’s Economic Battle

Shinzo Abe

Since the election of Shinzo Abe as Prime Minister in 2012, Japan has instituted a number of bold economic reforms (dubbed “Abenomics”) to try to jolt the country’s economy back to health after almost a quarter-century of stagnation. These reforms included increased government spending, more purchases of government bonds by the country’s central bank, deregulation, and new international trade agreements. Recently, however, Abenomics has hit a bit of a snag.

In April Japan’s consumption tax rose from 5% to 8%, a change that was agreed to in 2012 before Abe was elected. The tax increase took the air out of the Japanese economy, which contracted in both the second and third quarters of this year. The tax was scheduled to further increase to 10% next year.

In response to the economic fragility, the government has changed tack. The Bank of Japan, the country’s central bank, introduced move aggressive stimulus efforts. Abe stated that he would delay the second phase of the tax hike. And he announced that he would dissolve Parliament and call a new election to try to solidify support for his economic agenda.

Will the new efforts succeed? One of the interesting aspects about Abenomics (and a lot of economic policymaking more generally) is its somewhat circular logic: its success largely depends on how confident people are that it will succeed. If businesses believe that Abenomics will boost the economy and end Japan’s persistent deflation, for example, they’ll be more willing to raise their employees’ wages, which will help boost the economy and end deflation.

Japanese stocks surged after the central bank announced its new stimulus plan, suggesting that many investors still have faith that Abenomics can succeed. But if Japan suffers another hiccup like the recent effects of the consumption tax increase, Abenomics might not be able to recover.

Could Brazil Be the Next Japan and India?

Japan India Brazil

In recent years the world has experienced two elections in large countries that ushered in new governments pledging dramatic economic reforms and led to surging stock markets. In Japan in December 2012, the election of Shinzo Abe and his Liberal Democratic Party led to economic reforms known as “Abenomics” and big stock market gains in early 2013. In India, the election in May of Narendra Modi and his Bharatiya Janata Party also led to higher stock prices. Could Brazil’s stock market similarly benefit from its upcoming election?

Brazil’s poll, which will be held on October 5th (with a possible runoff vote later in October), pits the incumbent president, Dilma Rousseff, against a slew of opposition candidates. The most popular of these opposition candidates is Marina Silva, who only became a presidential candidate when her running mate was killed in a plane crash. Polls have shown Silva tied with or slightly leading Rousseff in a potential runoff vote.

A Silva victory could have large implications for Brazilian stocks mainly because investors tend to dislike Rousseff. Brazil has suffered from weak economic growth and high inflation in recent years, and its stock market has underperformed other emerging markets. Many investors have blamed these occurrences on Rousseff’s policies. Silva has advocated more restrained fiscal policies, reducing the inflation rate, and free trade agreements, all of which tend to be popular with investors.

Of course no two countries are identical, so there’s no guarantee that the Japan/India scenario will replay itself in Brazil. One of the biggest differences is that by the end of their campaigns Abe and Modi were romping to massive victories, while the Brazilian candidates are locked in a tight battle. But if Silva is able to pull out a victory, and has enough of a mandate to initiate investor-friendly reforms, Brazil’s stock market may follow the playbook set by Japan and India.

How Long Can Bond Yields Stay Low?

10Y US Treasury Yield

Despite numerous predictions that bond yields would soar (and therefore bond prices would fall), yields have actually fallen so far in 2014. After rising from record lows last year, the yield on 10-year US treasury bonds is currently around 2.5%, still far below its typical historical range. How long can bond yields stay so low? The answer is “possibly a very long time” based on the experiences of other countries.

The country that has the most experience with low bond yields is Japan. Following its real estate and stock market collapses a quarter century ago, interest rates started declining, with the yield on 10-year Japanese treasury bonds falling below 2% in the late 1990’s. It’s stayed below 2% almost constantly ever since, as weak economic growth and a low (even sometimes negative) inflation rate have given investors little reason to ditch the perceived safety of the country’s government bonds.

10Y Japan Treasury Yield

It’s unlikely that the US will experience such a lengthy period of such low yields. There are a few key factors working in favor of stronger economic growth for the US economy, such as more favorable demographic trends and an inflation rate that has mostly stayed in positive territory. In theory US policymakers should also be able to learn from Japan’s long stagnation to help avoid a similar fate.

Still, there’s no rule of economics that says that interest rates have to revert toward their average historical levels. The lesson from Japan’s experience should be that if economic growth remains weak and the inflation rate remains subdued (and there are plenty of economists who have this outlook), bond yields could remain low for a very long time.

The Biggest Political Risk

China-US Diplomacy

We recently discussed the rise in political risk that investors have had to deal with over the past few years. But where is this risk most likely to have a meaningful impact on US investors? The answer, perhaps surprisingly, is East Asia.

That answer may seem odd given the political uncertainties in other parts of the world. Syria has been racked for years by a deadly civil war, Iraq’s government is trying to fight off an insurgency, Russian-linked separatists have been stirring up trouble in Ukraine, and military leaders have claimed power in countries such as Egypt and Thailand. But when it comes to global financial markets, these countries are bit players. Even Russian stocks comprise only about one half of one percent of the value of the global stock market. While it’s true that events in small countries can have an impact—trouble in Syria or Iraq could spread throughout the Middle East and affect global oil supplies, for example—political risks related to larger countries would be more consequential.

Since 2012, a diplomatic conflict has been escalating between China and Japan over a group of uninhabited islands in the South China Sea. China also has territorial disputes with other countries in the region, including Malaysia, the Philippines, and Vietnam. So far these conflicts have remained mostly diplomatic rather than military disputes, but there are routinely provocations that threaten further escalation. Last month China stationed an oil rig in territory claimed by Vietnam, leading to riots in Vietnam targeting foreign businesses.

A military conflict between any of these countries could roil financial markets: Japan is the second-largest country in the iShares MSCI All Country World Index ETF, while China is the ninth-largest. Furthermore, the United States could intervene in such a situation (the US has a security agreement with Japan), making the strife truly global.

The good news is that the probability of a large-scale military conflict is still very low. Yet even if the disputes remain the purview of diplomats, investors could feel some effects: trade between China and Japan has fallen substantially since their territorial squabble metastasized in 2012.

Checking in on Abenomics

Shinzo Abe

When Shinzo Abe was elected as Japan’s Prime Minister in December 2012, he launched a bold plan of economic reforms that became known as “Abenomics”. These reforms included increased government spending, more purchases of government bonds by the country’s central bank, deregulation, and new international trade agreements. The aim was to jolt the country out of two decades of stagnation that had been characterized by deflation and mediocre economic growth.

Almost a year and a half into the implementation of this reform agenda, Abenomics appears to have made some progress. The value of the Yen, the country’s currency, has fallen by more than 20% since November 2012, helping Japanese exporters become more internationally competitive. The stock market has soared by 60% against the US dollar over the same time period (although for US investors some of that gain has been offset by the decline in the value of the Yen). Japanese wages rose in February for the first time in almost 2 years, suggesting that the quest to end deflation may finally be bearing fruit.

That doesn’t mean that Abenomics has been unequivocally successful. Many of Abe’s proposed regulatory reforms, such as breaking up the country’s electricity monopolies and loosening rules about how companies hire and fire workers, have struggled to gain support.  Some critics, such as economist Edward Hugh, argue that Abe’s attempts to stimulate the economy will ultimately fail.

The mixed outlook is reflected in the gyrations of Japan’s stock market: the overall rise since Abe’s election masks a few large drops, including a decline of more than 10% so far this year. Despite some early signs of success, the jury is still out on whether Abenomics will resuscitate Japan’s economy.