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Abenomics: time to think again?

International investors are recognising the progress that Abenomics has made in turning around Japan’s recently moribund economy. The long-awaited acceleration in domestic demand is finally taking place, while business confidence is high. But can this progress be maintained while inflation and government finances remain weak and North Korea pushes the region towards conflict?

Perhaps it is time for those who were drafting obituaries for Abenomics to put their pencils away. Prime minister Shinzo Abe’s three-arrowed plan for hauling Japan out of its protracted economic malaise has certainly had its fair share of detractors, who have criticised it for being long on rhetoric and grandiose ambitions and short on tangible results. 

As recently as last year, those critics were saying that Abenomics had failed to stimulate growth, failed to curb the strength of the yen, failed to ignite consumer confidence and above all failed to make meaningful progress towards the Bank of Japan’s 2% inflation target.

Today, many of those criticisms are beginning to look premature. In some cases they also look at least partially ill-informed.

Increasingly, international investors are recognising the progress that Abenomics has made in turning around Japan’s slow-moving economy. “After almost 15 years of uninterrupted deflation, it is time to forget about the lost decade,” noted one of these investors, Joel Le Saux, in early July, in an investment insight which outlined five reasons why investors should “go big in Japan”.

“Japan is back,” wrote Le Saux, manager of the Oyster Japan Opportunities fund at SYZ Asset Management, which returned 103% between February 2013 and the end of June 2017, outperforming the Topix Net Return by 18.1% over the period. “Abenomics may not have fully delivered on its much-vaunted promises, but the Japanese economic growth engine is steadily springing to life,” Le Saux commented. “Strong deflation pressures appear to have been consigned to the past, while the dual tailwinds of increased business confidence and consumer sentiment are boosting domestic Japanese business growth.”

Recent growth data seems to suggest that Japan’s recovery is sustainable. Hiroshi Nakaso, deputy governor of the Bank of Japan, somewhat understated the case in a speech in July, saying that Japan’s economy was expanding “moderately”. This, he added, was “the first time in about nine years — since March 2008, that is, before the collapse of Lehman Brothers — that the Bank [had assessed] the current situation of the economy as ‘expanding’.”

Nakaso was speaking well before the release of Japan’s stellar second-quarter growth numbers in August, which comprehensively wrong-footed many local as well as international economic forecasters. Real growth was 1% quarter-on-quarter (q-on-q), equating to a remarkable annualised rate of 4%, and making it six quarters on the trot that GDP growth was above potential. Japan has not posted consistent growth of that kind for 11 years.

The consistency and robustness of this expansion is all the more impressive given that — as BNP Paribas put it in a report published last year — “all in all, Japan’s potential growth rate is virtually nil”.

Unsurprisingly, the much better-than-expected second-quarter numbers sent economists scurrying to amend previous growth forecasts. Société Générale responded by revising its GDP growth expectations for this year from 1.3% to 1.8%, while Citi raised its forecast from 1.6% to 2%. Among Japanese banks, meanwhile, Nomura upped its forecast for FY2017 growth by 0.5 percentage points to 2.1% in August. That is marginally more upbeat than Daiwa, which has raised its GDP growth forecast for this fiscal year to 2% from a touch below 1.5%. 

Domestic drivers — better late than never

More significant than the absolute growth numbers is the clear shift in the drivers of rising GDP in Japan, which point to a long-awaited acceleration in domestic demand. “Until now the key driver of growth was external and related to strong export growth pulling up domestic demand components,” noted Société Générale soon after the release of the second-quarter data. “However, with both public and private demand picking up, growth drivers are starting to shift to domestic rather than external elements.”

For Japan, this marks quite a change. “The composition of growth is certainly encouraging because net trade actually subtracted from growth as exports fell,” says Chris Scicluna, executive director and head of economic research at Daiwa Capital Markets Europe in London.

Scicluna says that the 0.9% rise in private consumption in the second quarter, which was well ahead of expectations, needs to be interpreted with some caution, given the distortions that have been created in recent years by Japan’s somewhat erratic imposition of consumption tax. First introduced at a level of 3% in 1989, the tax has been increased in stages, with the most recent increase to 8% implemented in 2014. A further rise, to 10%, was planned in 2015 but has twice been postponed, and is now due to take effect in October 2019.

As Scicluna explains, 2014’s tax hike inevitably led to a surge in consumer spending immediately before the increase, with an equally inevitable fall in demand for big-ticket household items such as white goods after the rise. “Now it seems we’re returning to a more normal and sustainable level of consumer demand,” he says. 

There are plenty of more decisive drivers of consumer confidence and spending that are influencing domestic demand trends in Japan. Foremost among these is the tightness of the labour market, reflected in a decline in unemployment to below 3%, and the job-to-applicants ratio hitting its highest levels since the early 1970s.

Scicluna points out that there are about two million more people in employment now than there were when Abe took office. 

The lion’s share of these are accounted for by women entering the workplace, and in the early stages of the Abe administration much of the new job creation was contributed by part-time opportunities. But as Scicluna says, more recent patterns within the labour market have been more evenly balanced between men and women and have included more full-time jobs. 

“If you don’t feel safe in your job in Japan, you’re not going to feel safe in your job anywhere,” says Scicluna. “The recent dynamics in the labour force are very good news, especially against the backdrop of Japan’s shrinking working population.”

Business confidence riding high

It’s not just an increasingly self-confident consumer that is underpinning the strength of domestic demand in Japan. Another striking feature of the surprising performance of the economy in the second quarter was the 2.4% increase in capital expenditure. This chimes with recent business confidence surveys suggesting that Japanese manufacturers are a good deal happier today than they have been any time in the past decade. Confidence indicators are especially high in the construction sector. “You have to go back to before the real estate bubble to find confidence in the Japanese construction industry as high as it is today,” says Scicluna.

Buoyancy in the construction sector, twinned with a more general feel-good factor at a corporate and individual level, has been helped by investment in the run-up to the 2020 Olympic and Paralympic Games in Tokyo. The Tokyo Metropolitan Government (TMG) has estimated that in the 18 year period between 2013 (when Tokyo was awarded the mandate to host the Games) and 2030, the Japanese economy will see a positive impact worth more than ¥32tr ($283.5bn). 

Some ¥5.2bn of the value created by the Olympics will be accounted for by the so-called “direct affect” of direct investment and expenditure on hosting the Games, according to TMG’s calculations. The balance will be generated by legacy benefits such as infrastructure development and tourism receipts, which are one of the key pillars of Prime Minister Abe’s longer-term plan for revitalising the Japanese economy. Last year, the government doubled its target for foreign visitors to Japan to 40 million in 2020 and 60 million in 2030, and has introduced measures such as relaxing visa restrictions in support of this ambition.

“This demonstrates a shift from placing importance on simply maintaining levels of tourism to actively promoting its growth,” notes a recent update from SuMi Trust, which is also confident about the prospects for investment driven by the Olympics.

Reflation not yet on the horizon

Whether any of this will be enough to help push inflation towards the BoJ’s 2% target, and in turn support a longer term normalisation of Japanese monetary policy, is another matter, given that earnings growth has not kept pace with job creation. “The endless years of falling prices seem to be behind us, but we are not yet in a reflationary environment,” says Scicluna. “Inflation has been flat-lining between 0% and 0.5% year-on-year in recent months, and although it may reach 1% towards the end of this fiscal year, there are plenty of structural reasons why it is unlikely to go much higher than that.”

Alongside modest wage growth, these include limited prospects for an increase in manufacturing inflation given global competition, the low level of increases in administered prices as a result of government intervention and negative housing rental increases.

Others agree that Japan still looks a long way from reaching its 2% inflation target. The IMF cautions that “inflation remains stubbornly low amidst weak pass-through of monetary policy.” It adds that “widespread labour shortages have yet to translate into sustained wage growth and upward price pressure. Low labour mobility, a strong preference for job security, and wage setting based on past inflation constitute the main bottlenecks for triggering needed wage-price dynamics.”

The net result is that it is too early to start anticipating a return to normal monetary policy in Japan. “Given that the BoJ is committed not only to achieving but exceeding its 2% inflation target before calling time on its policy of quantitative and qualitative easing, there is not much of a case for expecting interest rates or target JGB yields to rise just yet,” says Scicluna. “Before this happens, we would need to see inflation expectations higher and the exchange rate significantly weaker.”

The sweet spot

All in all, however, Scicluna says that this is what he describes as a sweet spot for Japan’s economic recovery, and that the government deserves credit for what it has achieved since the announcement at the end of 2012 of what came to be known as Abenomics. “We have been cheerleaders for Abenomics because we thought it was refreshing to see a coherent and comprehensive package of macroeconomic policies and structural initiatives that have potential to deliver results in terms of growth, job creation and corporate governance as well as reform in the energy and agricultural sectors,” says Scicluna. 

This may mean that now is a better time to invest in Japanese equities than at any stage in the recent past. In its August survey of individual investors, Nomura found more than two-thirds upbeat about the prospects for the stock market, with 68.4% expecting the Nikkei-225 to rise over the next three months.

Retail investors’ enthusiasm for the equity market is shared by overseas commentators. “History shows that rising US interest rates have tended to be supportive of Japanese equities,” notes a recent update from Unigestion. “Such an environment tends to be associated with periods of solid economic expansion, and if the US economy continues to grow and interest rates move higher, as we expect, we believe Japanese equities should find additional support from this source.”

What could go wrong?

That may be. But none of this should be taken to suggest that there are no risks on the horizon for Japan. Unigestion identifies three sources of vulnerability for the economy, and therefore for equity investors. These are protectionism under the Trump administration in the US, a slowdown in the Chinese economy and the size of Japan’s public debt. “The Abe administration has pledged to turn the deficit into a surplus by FY2020, but that seems optimistic,” Unigestion observes. 

Japan’s government finances, described by S&P as “very weak” and a “significant constraint on creditworthiness”, have long been recognised as a vulnerability. Existing strains on the public finances, says S&P, were aggravated by the earthquake of 2011, which contributed to a rise in general government debt at an annual average pace of close to 10% of GDP between FY2009 and FY2012.

More recently, notes S&P, a pick-up in government revenue growth since FY2013 has helped to narrow Japan’s fiscal deficit.

“Looking ahead, we expect government debt to grow at a slower annual rate of 4.5% of GDP over fiscals 2016 to 2019,” S&P advises. “The corresponding increase in net general government debt will bring it to about 136% of GDP in fiscal 2020 from close to 126% of GDP in fiscal 2015.”

Although this makes Japan’s level of indebtedness among the highest of any country rated by S&P, the agency points out that because the BoJ now holds more than 42% of outstanding JGBs, the government’s borrowing costs remain low — for now. An increase in rates, remote though the possibility now looks, would “severely strain the government’s debt dynamics,” warns S&P. 

Rising rates would create a challenge for some Japanese companies, given that corporate debt in Japan is the second highest among G7 countries, at about 130% of GDP, according to the IMF. But as the IMF notes, corporate balance sheets have strengthened since the launch of Abenomics.

“With sizable equity holdings, corporate financial net worth improved as share prices rose in the wake of BoJ’s QQE programme,” the IMF reports.

“In addition, the yen depreciation raised export revenues, increased corporate profits and boosted corporate cash holdings for large firms.”

Investors agree that the Japanese corporate sector looks in better shape than it has for many years. “Following a cut in capacity and a closure of factories, we are seeing leaner Japanese companies grow profitability levels,” notes SYZ’s Le Saux in his recent update.

Another risk that may unsettle investors in Japan is sabre-rattling on the Korean peninsula. As Nomura advised in response to North Korea’s recent belligerent announcement about Guam, “we cannot ignore the geopolitical risks posed by this situation.” This angst can only have been aggravated by the provocative missile fired over the Japanese mainland at the end of August.

The demographic challenge

Looking to the much longer term, one of the most intractable challenges Japan faces is its demographic profile and fast-shrinking population. According to a recent report published by the Mizuho Research Institute (MHRI), by 2100 the population is projected to fall to 50m, compared with about 126m in 2016. 

“In addition to measures to deal with the low birth rate, a key to dealing with Japan’s long-term population is to expand immigration,” notes the MHRI report, adding that a “radical change in thinking” will be required if immigrants are to be welcomed. 

There are indications that after being hesitant for many decades on the subject of immigration, the government is at last introducing initiatives to encourage rising inflows of immigrants. “On the reform side, measures such as the introduction of the new Japan Green Card for highly skilled foreign professionals, together with deregulation to encourage entrepreneurship and attract overseas workers to the healthcare sector are promoting increased foreign participation in the workforce,” says Scicluna. 

The good news, he adds, is that initiatives such as these have helped add some 160,000 foreign residents to the Japanese workforce over the past year. The less positive news is that this number is about half the decline in the population, which, according to MHRI, has now contracted for eight straight years since peaking in 2009. Last year’s decline, MHRI adds, was the largest since the annual Basic Resident Registry tracking the size of the population began in 1968.