Fundamental change in Japan is unlikely

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Michael Stanes, Investment Director at Heartwood Investment Management

Japan has been making all of the headlines lately, with unexpected additional monetary stimulus at the Bank of Japan (BoJ), the upcoming snap elections in December, 2014, and an announced delay to the second phase of the VAT hike, which was due to be implemented later in 2015. The domestic equity market has rallied 17% since October  21st, 2014 (to 21st, November, 2014), while the yen has depreciated 10% against the US dollar for the same period.  Has Japan reached an inflection point?

Without sounding too much like a broken record, the jury is still out on whether Japan is fundamentally changing beyond an attempt to depreciate the yen. Near-term investor sentiment and economic momentum have improved, and the BoJ will fight hard to keep inflation in positive territory; it has been late in recognising that its target of 2% in 2015 is unlikely to be achieved.  So far, these accomplishments have been achieved through a unilateral strategy of yen weakness, but this tactic alone won’t be enough to improve the longer term growth rate, while it also increases the risks of destabilising regional growth prospects more generally across Asia.

Essentially, Japan needs to revive domestic demand. However, that remains contingent on implementing significant structural reform, part of Prime Minister Abe’s “third arrow” framework.

Marginal efforts have been made, such as Abe’s announcement in the summer to lower corporate tax rates in 2015, where it is hoped that the improvement in corporate profits will feed into wage growth, which has risen moderately on a nominal basis (0.5% y-o-y) but remains negative in real terms (-2.9% y-o-y). However, even if these initiatives prove beneficial, they will take time to filter through into the real economy; moreover, they only comprise a small part of the overall solution.

More substantive changes are needed including: deregulating domestic industrial and services sectors; opening economic borders to foreign competition, in particular, progressing the Trans-Pacific Partnership; reforming the agricultural sector; liberalising immigration laws to address the structural decline in the working age population.

Abe and other reform-minded politicians know what needs to be done. However, they remain a minority within a political establishment dominated by vested interest groups, which are reluctant to see fundamental change.  The outcome of the elections in December 2014 might edge the reform agenda further, but based on recent history, in particular the euphoria surrounding Prime Minister Koizumi ‘s sweeping victory in 2005, investors’ hopes might quickly give way to disappointment as the status quo continues. Does “Abenomics” really exist?

For these reasons, we remain neutral in Japanese equities. The rally in Japanese equities has so far been driven by the weak yen trade rather than meaningful economic fundamentals – the risk is that politicians will once again disappoint investors.


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