Marcel Thieliant, Senior Japan Economist at Capital Economics, believes the outlook is positive for Japan’s economy – and for Japanese equities.
In the four years since he returned to power Shinzo Abe, the Japanese prime minister, has chalked up several successes.
For a start, the economy has been growing strongly by historical standards, helped by an unprecedented surge in the proportion of working-age women in paid employment.1 On most estimates, growth has been above what is sustainable in the long term. As a result, the unemployment rate has fallen to a 23-year low2 and the ratio of job offers to applicants matches the highs reached during the 1990s bubble.
Moreover, the outlook remains upbeat. GDP should grow by 1.5% this year,3 which would be the strongest rise in four years; external demand should continue to expand; and consumers are finally awakening from the slumber they fell into following the 2014 sales tax rise.
Another positive is the uptick in corporate profitability. Since the end of 2012, aggregate gross profit margins have risen by 50% to reach a record high – the improvement was particularly pronounced in the non-manufacturing sector. After-tax profits have been further boosted by a cut in the corporate tax rate from nearly 40% in 2012, to just under 30% now.4
However, the challenges of adverse demographics and low productivity remain to be addressed. The main obstacle to stronger growth in Japan over the medium term remains the continued rapid contraction of the working population. The number of foreign workers has been rising rapidly recently, but immigration remains too low to halt the decline in the working population. A comprehensive policy to encourage immigration has not been enacted.
Meanwhile, one of the key factors holding back productivity growth is the low presence of foreign firms. Due to high non-tariff trade barriers and opaque regulations, Japan’s stock of inward foreign direct investment is the lowest among OECD economies. Moreover, policymakers have not followed through on pledges to deregulate: in 2012, the government set a goal of being placed in the top three in the OECD in the World Bank’s Doing Business report. Instead, Japan has fallen back from 14th place in 2012 to 26th in 2017.5
What's more, 'Abenomics' (as Shinzo Abe's economic policy package is known) has largely failed in one of its key goals, which was to generate inflation after years of deflation. Granted, inflation strengthened in the year after the Bank of Japan (BoJ) launched its aggressive asset purchase programme. But that reflected a temporary boost from higher import prices and a brief spurt in domestic demand ahead of the sales tax increase that was introduced in 2014. Inflation has since fallen back and, on most measures, it is currently around zero.
The immediate explanation for why inflation has failed to pick up is that wage growth has remained subdued, despite the continued tightening of the labour market. With productivity growth of just under 1%, wages would have to rise by around 3% to reach the 2% inflation level targeted by the BoJ. In reality, wage growth has remained closer to 0.5%.
The main reason that aggressive monetary easing has not generated stronger wage growth and inflation is that the BoJ has had no success in lifting expectations of future price gains. Households’ five-year inflation expectations fell to a seven-year low last quarter, and firms expect prices to rise by just 1% per annum over the coming five years.
Last September, the BoJ pledged to keep expanding the monetary base until inflation had settled above its 2% target. However, it is unlikely the bank will be able to declare victory any time soon. That isn’t necessarily a disaster, as the economy has continued to grow at a robust pace, even as price pressures have remained subdued. Indeed, in the second quarter it grew by a stunning 1.0% versus the previous three months.
Moreover, credit growth is at the highest level it has been in at least two decades. While that might have encouraged the BoJ to raise rates, inflation remains relatively low – and so monetary policy is likely to need to remain loose for the foreseeable future. In particular, the BoJ is likely to keep its 10-year yield target unchanged at 0%. By contrast, the majority of analysts on a poll conducted by Reuters earlier this year expected the BoJ to start tightening policy by the end of next year.6 Most expect it to start by lifting its yield target.
Meanwhile, Capital Economics expects the US Federal Reserve to lift rates during 2017-18, which is more than most analysts anticipate. We expect 10-year US government bond yields to climb to 3% by the end of this year. If we’re right, interest rate differentials will widen in favour of the dollar. Our forecast for the end of the year is 120 yen to the dollar (against some 110 yen to the dollar now).
What would this mean for the equity market? In recent years, Japanese equities followed changes in the exchange rate of the yen versus the dollar. A weaker yen tends to lift export earnings, which are mostly invoiced in foreign currency. It also lifts the yen value of the profits of overseas subsidiaries, which have grown in importance. In 2016, the sales of overseas manufacturing subsidiaries were equivalent to one-third of domestic sales, and the figure is higher for the multinationals listed on Japan’s stock market.
A further weakening of the yen should provide a tailwind for Japanese equities. Valuations are a long way from their frothy bubble-era peaks. At Capital Economics, we expect that Japanese equities should do better than US equities, which we expect to falter this year.
1 japanpolicyforum.jp, June 2016
2 bccjapan.com, March 2017
3 asia.nikkei.com, December 2016
4 asianikkei.com, November 2016
5 doingbusiness.org, May 2017
6 reuters.com, March 2017
The opinions expressed are those of Marcel Thieliant, Senior Japan Economist at Capital Economics and are subject to change at any time due to changes in market or economic conditions. 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 strategy. The views are not necessarily shared by St. James's Place Wealth Management.