Will Abenomics finally bring an end to Japan’s lost decades?

Yes

Peter Jenkins

Investment specialist, Nomura Asset Management UK

Peter Jenkins, Nomura Asset Management UK

Few investors can have failed to notice the stunning performance of Japanese equities in 2013, with the market propelled by investor enthusiasm over ‘Abenomics’, the package of fiscal, monetary and upcoming structural reforms named after Shinzo Abe, the Japanese prime minister.

Abenomics is an initiative designed to shake Japan out of the torpor which resulted from private sector deleveraging following the collapse of the great Japanese ‘bubble’ of the 1980s. Japan’s ‘lost decades’ have been characterised by sluggish growth and deflation as well as ballooning  government debt as successive administrations sought to cushion the economy through ever larger fiscal packages. With gross government debt to GDP having risen inexorably to well over 200 per cent, this approach is clearly unsustainable and the LDP administration of Mr Abe appears to have finally grasped the nettle.

Abenomics has three main strands, or ‘arrows’. To date the most tangible effects have come from the ‘monetary arrow’; the radical quantitative easing by the Bank of Japan involving massive asset purchases in an attempt to move from persistent deflation towards an inflation target of 2 per cent. Unprecedented monetary stimulus has led to a major fall in the yen as it corrected from its extreme overvaluation in 2012. A weaker yen has boosted the earnings outlook of Japanese corporates which has been reflected in higher equity prices. The ‘fiscal arrow’, comprising further public spending initiatives to improve social infrastructure, has also been supportive.

Attention has now turned to the third arrow, the economic reforms that are probably the key aspect of Abenomics, in that they alone have the potential to raise Japan’s longer-term growth prospects. However, structural reform is not easy; it may promise longer-term economic improvement but in the short term it often involves a degree of pain to much of the economy. Hence, supply side reforms struggle to find favour with democratic governments, including successive Japanese governments.

This makes many commentators sceptical that Japanese politicians will have the stomach to push ahead. However, we believe that circumstances are now propitious for just such a change. Japanese voters have continued to support the current administration with Mr Abe winning both a Lower and Upper house election while openly calling for radical reform.  He has maintained a popularity rating of close to 50 per cent, a notable achievement in the land of the ‘revolving prime minister’.

It appears the electorate is starting to believe that now is the time for robust action if Japan is to avoid slipping into irrelevance in the shadow of China. Simply put, Japan has no choice but to embrace change, even if it proves painful.

So what are investors looking for on the supply side? In short, anything which will help the economy to return to robust growth. They are looking for measures to increase industrial competitiveness, the overhaul of energy policy, changes to the tax regime, reforms of labour laws as well as changes to health and welfare provisions.

Given Japan’s recent history of shirking painful reforms, many remain unconvinced. However, in one respect significant change is already underway. In 2013 Japan signed up to the Trans Pacific Partnership, a collection of Pacific Rim countries aiming to work towards reducing trade barriers and promoting free trade. While negotiations are not yet complete, there is little doubt that there will be major changes to tariffs which will in turn remove some of the protection enjoyed by cosseted domestic segments of the Japanese economy.

While we do not underestimate the difficulty and scale of the task ahead, we believe that the signs are more encouraging than they have been for many years. A politically secure and pro-active government plus a supportive population gives us grounds for optimism. Japan’s lost decades may at last be set to fade into history.   

No Mads Pedersen

Co-head of asset allocation at UBS Wealth Management

Mads Pedersen, UBS Wealth Management

Radical policy announcements aimed at growing and reinflating the Japanese economy – Abenomics – may have devalued the yen and sent stocks soaring, but in the long term, investors should remain cautious over Abenomics’ apparent success.

The first test for Shinzo Abe’s second arrow – flexible fiscal policy – comes in April 2014, when the consumption tax will increase from 5 per cent to 8 per cent. To dampen the negative effect on economic growth, the government issued a stimulus package in the range of Y6-7tn (€42-49bn). The consumption tax hike has an immediate negative effect on consumption, whereas the agreed countermeasures include tax incentives which work only in the longer term and will not translate one-to-one into higher economic growth.

Moreover, past fiscal programmes will also end at the start of the new fiscal year. While the consumption tax increase is a welcome step in the direction of consolidating Japan’s fiscal position, it might hamper economic growth.

Investors’ hope currently rests on the first arrow – the Bank of Japan (BoJ) and its new monetary policy. Under its new leadership, the BoJ announced in April 2013 that it would double its balance sheet within two years. The BoJ made clear it will do whatever deemed necessary to overcome deflation. In response to large scale purchases of Japanese government bonds, equity ETFs and Japanese real estate investment trusts, the yen weakened sharply and helped stoke inflation. With the effect of yen weakness diminishing and economic growth likely to slow from the second quarter on, the BoJ’s 2 per cent inflation target seems demanding. Therefore, investors expect the BoJ to engage in additional monetary easing, which might put upward pressure on equities.

However, investors can expect further disappointment from the third arrow – the growth strategy. Widely anticipated measures to liberalise the labour market and to increase labour market participation have not been passed. Despite the fact that the next general election is not until 2016, vested political interests are making it difficult to reform the labour market, as well as the corporate and agricultural sectors. We do not foresee much progress here.

To achieve self-sustaining growth, the broader Japanese economy needs to benefit from the weaker yen beyond a one-off boost to corporations’ bottom lines. Corporations, however, are only reluctantly increasing fixed investments. Whether the private sector will start to increase wages, as demanded by the government, will be seen in the coming spring wage negotiation round. So far, Japanese consumers face the burden of rising prices, but have not experienced base salary increases.

Lastly, Japan’s public debt amounts to more than twice its GDP. For deleveraging to occur in the long run, higher trend growth would be beneficial. Without structural reforms and with unfavourable demographics, a lift to Japanese trend GDP growth seems unlikely.

The BoJ will have to ease monetary policy further if it wishes to drive the recovery forward. Such easing would only be enacted in the second quarter of this year. While this action would weaken the yen and help earnings advance, we prefer to wait for clarity regarding further BoJ easing. We are adopting a neutral stance on Japanese equities. We recommend that investors position themselves for the yen to weaken against the dollar and that they hedge the yen exposure of their Japanese equity holdings back to their home currencies.