A new era in Japan

Japan welcomed Yoshihide Suga as its new Prime Minister last week. As former Prime Minister Shinzo Abe’s right-hand man for more than eight years, Mr. Suga enjoys a reputation of being a reformer and a problem solver. In today’s note, we look at how policies might evolve in the Suga era, the challenges the next government is facing, and what it means for investors.

The biggest downturn

The new prime minister faces a full slate of challenges. The world’s third largest economy is still emerging from its worst downturn since the 1950s. Severe disruptions to domestic demand and exports caused by the COVID-19 pandemic put further pressure on a Japanese economy that was still struggling with the effects of a consumption tax hike in 2019. Despite declaring a national emergency in April, Japan only carried out limited mobility restriction measures and refrained from closing businesses, but economic activity, especially in services and manufacturing, still plummeted.

Recent data suggests the economy has passed the trough, as retail sales recover thanks to the government’s large-scale cash handouts. However, the manufacturing sector has lagged the recovery due to weak global auto demand and high inventory levels. Inflation is expected to face continued downward pressure due to a persistent output gap, but should avoid outright deflation. Overall, we expect production to be below pre-pandemic levels by the end of 2021. 

The legacy of Abenomics

Shinzo Abe has defined Japan’s economic policies over the past eight years, with his so-called "Three Arrows". The first version of the "Three Arrows", from 2012-2015, consisted of unlimited monetary easing, pro-active fiscal policy and structural reforms to boost private sector investment. The agenda was further expanded in 2015 to include policies to raise birth rates and reform the labor market. As Japan’s longest serving post-WWII Prime Minister, Abe invested considerable political capital in these policies, going as far as to change the laws regulating the central bank. These policies signaled his determination to revitalize Japan’s economy, which had suffered three "lost decades" of anemic growth and depressed asset market returns prior to him taking office.

These policies have resulted in some dramatic shifts in Japan’s asset markets. The Bank of Japan’s Qualitative and Quantitative Easing (QQE) and negative interest rate policies since 2016 led to a near 30% depreciation of the JPY vs. a basket of currencies (at 2012 to 2014 levels). Real (inflation-adjusted) interest rates fell by 200bps between 2012 and 2016. Japan’s equity market indices more than doubled between 2012 and 2019. There were also changes in the real economy. Corporate sector profit growth accelerated in 2013 and 2017, while Abe’s "Womenomics" has increased female participation in the labor force by 5ppt between 2012 and 2020. From 2013 to 2017 labor productivity growth was among the highest in G7 countries. Japan was a leader in putting together the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) and played a big role in the Regional Comprehensive Economic Partnership (RCEP). Japan also sought bilateral agreements with the EU and U.S. as well as free trade agreements with China and South Korea. 

Nonetheless, Abenomics fell short of its goals in other aspects. Most notably, the aggressive easing has not brought about the desired pickup in inflation. Meanwhile, the pass-through from corporate profitability to labor income was also weak. Wage growth has stayed anemic in the last eight years – which also weighed on inflation expectations. This is partly because the implicit "lifetime" employment rule makes both firing and hiring very difficult. Weak household income growth exacerbated the negative impact of the consumption tax hikes – which had pushed Japan into economic contraction in 2019. Nor did a weaker currency reverse Japan’s declining share of global exports, which continues to hover around 4%, mostly due to corporate Japan largely already moving manufacturing offshore. 

More importantly, after eight years of expansionary policies, there are now diminishing returns with regard to the first two arrows of monetary and fiscal easing. As of August 2020, the Bank of Japan (BOJ) owns half of all outstanding JGBs and over 80% of outstanding ETFs. Its total ownership of government and corporate sector bonds and ETFs has exceeded Japan’s GDP in 2019. The worry that there will not be "enough" assets left for the BoJ to purchase has already emerged prior to COVID-19 – prompting some policy adjustments in 2019. The marginal effectiveness of monetary policy in influencing interest rates, currency and inflation expectations has also declined. From a fiscal perspective, raising taxes again after the devastation brought on by COVID-19 is out of the question. Thus, future governments will ultimately need to raise tax rates on the corporate sector. To avoid overly penalizing the corporate sector, the government will need to simultaneously reduce the corporate sector’s labor costs by removing the implicit guarantees of lifelong employment. This is a set of interrelated issues that future administrations will likely face.

How policies could evolve under PM Suga?

We think the economy will be the main priority for Prime Minister Suga. He will likely continue the Abenomics path, including a coordinated fiscal and monetary policy approach by the government and the BOJ. PM Suga has also indicated a strong desire to tackle structural reforms and deregulation, especially in the area of digitalization, where he has already promoted transforming administrative procedures and called for the establishment of a "Digital Agency.” Although sometimes overlooked as an increasingly tech-driven economy, a critical digital transformation is still well under way and will work in favor of Japan, which faces significant demographic challenges.

Lastly, on the foreign policy front, Mr. Suga has emphasized the importance of maintaining the U.S.-Japan alliance, as well as his intent to build stable relationships with neighboring countries.

Investment Implications

Japan is well-positioned for a post-COVID-19 world, due to (1) the continuation of Abenomics reforms, (2) post-COVID-19 technology investments and reform initiatives, (3) trade agreements with key global economies and a strong alliance with the US, and (4) macroeconomic resilience with low unemployment.

We remain selective on Japanese equities, favoring leaders in gaming, technology, and digitalization. We also see a stronger JPY against USD over the medium term. The fact that real yields in Japan are currently higher than those in the U.S. lends strong support, as the USD/JPY currency pair tends to follow the interest rate differential between the two currencies. We expect real rates in Japan to stay higher given persistent deflationary pressure. And though monetary and fiscal policies in Japan will likely stay accommodative, the country has less policy tools at its disposal to launch further large-scale easing. 

All market and economic data as of September 21, 2020 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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