Japan story too strong to be ignored by the central bank

By Stéphane Monier Chief Investment Officer Lombard Odier Private Bank

The Japanese economy is showing signs of strength that the central bank will not be able to dismiss for long. One of the key macroeconomic questions for 2018 is how long it will take the Bank of Japan (BoJ) to engage in the kind of policy normalisation that we have already seen in Europe and the US. We believe some form of change is inevitable and will support a stronger yen (JPY), while sentiment around the Tokyo stock market will remain bullish.

Coming off the drugs?

The BoJ has been one of the world’s most accommodative central banks. At its last meeting on 20 December the bank kept short-term interest rates at a negative 0.1% and its target for 10-year government bond yields at 0%. The BoJ holds more than 40% of outstanding government debt, and has also built a significant position in the equity market through exchange traded funds (ETFs). The bank will next communicate to markets on 23 January. There is unlikely to be any major shift in monetary policy, but investors will be keen to hear any hints from BoJ governor Haruhiko Kuroda that the bank sees signs of strength which might prompt it to withdraw some of its support sooner rather than later. Inflation may still be well below the bank’s target of 2%, but we believe it is advisable for investors to position themselves in good time for potential changes. The latest signal of a thriving Japanese economy came on 17 January, when data showed November orders for machinery reached their highest level in a decade, as companies finally started to spend some of their large cash reserves.

The benign conditions have come on the back of the “Abenomics” policies enacted by Prime Minister Shinzo Abe. His “three arrows” brought a focus on monetary easing, structural reform and fiscal stimulus and managed to drag Japan out of a period of malaise. The latest round of proposals includes targeted tax cuts for companies that increase wages or make investments in new technologies.  It is another tilt at those corporate cash piles and could bring a firm’s tax rate down as low as 20% from 30% currently. In contrast to the US, there are also tax hikes for the highest earners. We think these are positive measures for the long term.

Coming back to today, it is clear that when the world ramps up production and investment, Japan’s industries benefit through increased global trade. The pattern has held reliably over time and certainly last year. In the third quarter, real GDP growth confirmed that the country had been enjoying the longest uninterrupted stretch of expansion since the era of former Prime Minister Junichiro Koizumi (2001-2006). Just about every major cyclical indicator points to a robust economy. Unemployment is at 2.7%, the lowest since 1993. In fact, the job market is so tight that for high school or college graduates getting a job is becoming a question of will, not skills. Women are responding as well, as their labour-force participation rate has risen sharply to more than 70%¹. Tokyo will host the 2020 Olympic games, and with related construction deadlines fast approaching, it is reasonable to expect this will help solid conditions to persist.

One indicator that has been disappointing in spite of it all has been inflation, but even this might be changing. Headline inflation began to bounce back from very low levels during the final quarter of 2017. Due to exceptional tightness in the market, part-time wages have been rising steadily, and supportive external conditions, including high crude oil prices, point to price pressures. Whatever happens, the BoJ faces a delicate communication task, not least because political support for 2% inflation is probably weaker than meets the eye: the country’s challenging demographics have given it a cohort of pensioners living off fixed income and who are no fans of rising prices.

Yen looks like the G7’s most competitive currency

Despite some recovery since the fourth quarter, the JPY’s trade-weighted, relative-price-weighted value versus a basket of currencies remains very close to its multi-decade low. Indeed, the currency’s real value hasn’t appreciated much, despite the slight recovery in domestic prices and apparent appreciation versus other currencies, because domestic inflation has been substantially higher elsewhere.

More to come from equities

The Japanese stock market had a spectacular rally in 2017, up 19% on the year in a continuation of a run starting in mid-2016, when the “three arrows” began to find their mark. Recent gains have been led by small caps which are most sensitive to the changes in corporate behaviour driven by policy. Japan is the most cyclical of all markets, and has the most operational leverage, and as such is a geared play on global growth. One reason for this is that Japanese companies have a very strong global position in certain boutique markets for precision parts and equipment, for example micro-motors, zip fasteners, containers for silicon wafers and bicycle gears and brakes. With global GDP growth forecasts from the International Monetary Fund for 2018 of around 3.7%, we think Japan is a good place to be invested for that reason alone. We are more cautious on the ability of small caps to continue outperforming large caps by as much as last year.

Based on Price/Earnings ratios, Japan stands out as one of the few markets in the world that appear fairly valued. Most other major equity markets look overbought relative to their long-run averages. A stronger yen represents a risk, of course, but the cyclical boom should offer enough support, while the BoJ’s natural caution should reduce the chance of overly aggressive tightening which would act as a drag on sentiment.

There are risks to the rosy scenario. A geopolitical crisis involving North Korea is a diminishing but tangible pressure point, while bungled BoJ communications could dampen investor appetite through a much stronger yen, and global cyclical conditions might not be as solid as we expect. But the positive story is hard to ignore, and we suspect will be impossible to ignore for a central bank running out of purchasable assets and faced with an improvement in economic conditions following the Abe administration’s structural reforms.

¹ OECD Labour Force Statistics/Brookings Institution.