Authors: Julia Wang, Cameron Chui, Weiheng Chen
At the outset of 2024 we told investors that it would be a year of elections, which could be a key driver of market movements. But Japan wasn’t on our radar. Following a snap election Japan now faces an uncertain political environment, as the Liberal Democratic Party (LDP) – who have governed for nearly all of Japan’s postwar years – have just lost their parliamentary majority for the first time since 2009.
We have been constructive on the structural opportunity in Japanese equities since last year, based on the fundamental reflationary dynamics in the economy, a relatively accommodative Bank of Japan (BoJ) and the steady pace of corporate reforms. However, could this political change upend Japan’s relative stability? And what about the potential impact from the U.S. elections next week?
What we think
Our positive investment thesis for Japan is still intact. The economy is going through a regime shift from deflation to reflation, and it appears sustainable due to resilient inflation expectations. Near-term political turmoil doesn’t appear to impact the macro environment in an immediate way, but reduced policymaking ability can be a negative for the economy. However, we see a relatively lower risk of an economic derailment. Key to that view is that other key political parties have advocated for economic stimulus via tax cuts and fiscal spending, and the potential political scenarios likely imply relatively expansionary fiscal outcomes that could be supportive for the economy.
Investment implications
With recent corporate earnings revisions remaining positive, tailwinds from recent JPY weakness, potential upside from greater cash returns to shareholders, and a near-record valuation discount to U.S. equities, we find the risk/reward for Japanese equities attractive. Increased volatility in the currency is likely, but we continue to see a gradually stronger yen on narrowing rate differentials in the medium-term as U.S. rate cuts proceed. JPY hedging is not necessary for Japanese equity positions.
In this week’s Asia Strategy Focus, we assess how the new administration and the upcoming U.S. elections could impact Japan’s macro and market outlook and consider the opportunities and risks for investors.
Why were these elections significant?
Results from Japan's general election on Sunday confirmed that the LDP coalition (with Komeito) won a combined 215 seats, failing to retain a majority (233) to form a government, while the largest opposition party, the Constitutional Democratic Party (CDP), gained 52 seats to reach a total of 148.
THE LDP LOST ITS MAJORITY FOR THE FIRST TIME SINCE 2009
Japan parliament lower house seats by election
The following bar chart shows the breakdown of seats in the Japanese parliamentary elections. The green bar represents the LDP (Liberal Democratic Party). The purple bar represents the Komeito, and the dark blue bar represents the main opposition party in Japan. The majority is shown by the red dotted line at 233 seats. The graph shows that in most elections since 2005, the LDP has always gained the seats needed to maintain an absolute majority in the Japanese parliament. There are only two exceptions. The first was in 2009, when the LDP only gained 119 seats in the election. The second time was this year, when the LDP only gained 191 seats in the election. Thus, there is no party in the Japanese parliament that holds an absolute majority right now.
Prime Minister Ishiba, who only took office on October 1st, is now under pressure. This political uncertainty echoes the ‘revolving door’ period of Japanese prime ministers around the last time the LDP lost its majority, and before the era of relative political stability under the late former Prime Minister Abe who was in power from 2012-2020. During that time Abe implemented his famed “Abenomics” economic policies - including easing monetary policy, providing fiscal stimulus, and structural reforms, which have, to some extent, underpinned Japan’s economy and markets to this day.
As a result of this elevated uncertainty, Japanese markets have been understandably de-risking into the elections, with equities and the yen both selling off, in contrast to their usual inverse relationship (where a weaker yen tends to bode well for Japanese equities). Though stocks have since stabilized, plenty of questions remain around how the weakened government could implement fiscal policies, how the BoJ could approach policy tightening, and whether foreign investors (who have helped propel Japanese equities to record levels) may lose confidence in the market.
JAPANESE STOCKS AND USDJPY HAVE MOVED TOGETHER FOR MOST OF THE YEAR, BUT THEIR PATHS HAVE DIVERGED IN RECENT WEEKS
The following line chart shows the movements of the Topix and the exchange rate of USD/JPY from January 1st, 2024, to October 30th, 2024. The dark blue line represents the exchange rate of USD/JPY, while the aqua line represents the Topix. The graph shows that for most of the year, the Topix and USD/JPY moved in similar directions. When the Topix rallied, it was matched by a strengthening of the USD against the JPY. When the Topix fell, we also saw the USD depreciate against the JPY. As highlighted by the red dotted circle, the Topix and the USD/JPY exchange rates diverged from their usual pattern. When the Topix sold off in October, so did the JPY against the USD.
Do the election results impact our outlook for Japan?
Investors in Japan have faced a number of shocks in the last few months, including the historic 3-day 20% sell-off in the TOPIX in early August, a sharp appreciation of the JPY, and now concerns over whether current domestic political uncertainties could derail Japan’s economic recovery due to policy changes. In addition to this are the potential implications in the event of a Trump presidency.
Our positive investment thesis for Japan is still intact. The economy is going through a regime shift from deflation to reflation. This means Japan deserves a structural allocation within portfolios in a way that wasn’t the case in previous decades, even if near-term uncertainties have picked up.
Can reflation be sustained?
Evidence that reflation is sustainable lies in the resilience of inflation expectations. After reaching a multi-decade high, indications are that next spring’s negotiated wage settlement could again coalesce around at least a 5% year-on-year increase, a sign of a more entrenched price outlook. Capex spending intentions continue to look strong as corporates are now compelled to invest into labor-saving, productivity-enhancing technologies, due to a historically tight labor market.
JAPANESE COMPANIES ARE LOOKING TO CONTINUE CAPEX GROWTH
Ministry of Finance survey, software and investment into plants and equipment, quarterly % change
The line graph shows the quarterly change in Japanese companies’ investments in software, plants, and equipment from 2004 to 2024. The dark blue line shows the composite of all industries. The aqua line shows manufacturing companies, while the purple line shows non-manufacturing firms. The graph shows that investment growth by Japanese companies has mostly stayed positive, with a few exceptions. During the years around the Great Financial Crisis between 2008 and 2011, Japanese companies' investments shrank significantly. Manufacturing companies’ investments diminished the most, reaching -34% in early 2010. For the remainder of the 2010s, Japanese companies’ investments mostly grew quarter on quarter. That trend changed again after the COVID pandemic hit in 2020. From 2020 to 2021, Japanese companies again lowered their investments on a quarterly basis. Investments returned to positive quarterly growth after the second half of 2021. Since then, investment growth has remained positive quarter on quarter.
But more is needed to convince investors from a cyclical perspective, and the data looks mixed. On consumption, lingering dissatisfaction with the inflation shock continues to weigh on consumer activity. This could be due to real wages not yet turning decisively upward, and we believe a bigger cyclical growth upturn is needed for this to happen. Furthermore, it simply takes time for consumer behavior to change, especially after years of entrenched deflation.
REAL CONSUMPTION IN JAPAN HAS CONTINUED TO LAG DUE TO INFLATION
Japan consumption, adjusted for tourism, indexed 2015 = 100
This line chart tracks consumption activity in Japan, adjusted for tourism. The dark blue line represents real consumption activity, while the aqua line represents nominal consumption activity. The dark blue and aqua dotted lines show consumption activities before the pandemic, with 2015 indexed at 100. Between 2020 and 2022, the graph shows that nominal and real consumption activities have stayed closely correlated. After 2022, however, there is a divergence between real consumption activity and nominal consumption activity. Nominal consumption activities have increased to above pre-pandemic trends due to a rise in inflation. However, real consumption activities have stayed below pre-pandemic trends, as real wage growth lags behind inflation.
Exports have been a bright spot since late last year, but have been slowing in recent months. The path forward for exports could be more divergent depending on how the U.S. elections could potentially change the global trade environment next year.
In our base case, we assume the corporate sector continues to invest and that export growth could see a stronger cyclical pickup in the next two years. This could create a stronger growth recovery and a more positive outlook for real income, persuading consumers to spend more. A more fully-fledged consumption recovery could lay the groundwork for the BoJ to raise rates in a gradual and predictable manner, which may help to end the perpetual political angst over the weak yen, and lead to a more balanced distribution of the economic benefits of reflation.
How could a weakened government impact the economy?
The near-term political turmoil doesn’t appear to have immediately impacted the macro environment. A weakened government is less likely to pass any game-changing policies, and the immediate market reaction also suggests investors think a weaker government reduces the political cover required by the BoJ to hike rates in the coming months and quarters, resulting in slower and smaller hikes that are positive for risk assets. The BoJ’s October Monetary Policy Meetings also turned out to be a non-event, with minimal changes to the economic assessment or forward guidance. However, we wouldn’t push this argument too far. Policymakers may try to push back on a ‘no hike’ outcome as they want to avoid a repeat of the August 2024 carry trade unwind experience, which destabilized markets.
In the medium-term, a reduced capacity to implement policy can be a negative for the economy. A minority government that has to achieve legislation through ad-hoc agreements with factions within the opposition will likely not be able to focus on boosting economic growth or generating a stronger domestic consumption recovery. Such a government is also unlikely to have a long tenure. Pundits point to the July 2025 upper house elections as another major political hurdle that could weaken the LDP’s position, and keep the door open for opposition parties to vie for more influence.
Looking ahead, there are three potential political outcomes:
a) The LDP manages to bring in additional parties to form a grand coalition.
b) The LDP forms a minority government with support from smaller parties on a case-by-case basis.
c) The CDP forms a grand coalition.
By law, the Prime Minister must call a special session of the Diet to vote on the next Prime Minister within 30 days of the general election. While the outcome is likely to remain uncertain for now, it appears that B is the most likely scenario, followed by A. Both the Innovation Party (IP, 38 seats) and the Democratic Party for the People (DPP, 28 seats) hold enough seats individually to hand power to the LDP if an expanded coalition can be formed (the current LDP coalition is 18 seats short of a majority).
We see a relatively lower risk of an economic derailment. Key to that view is that both the IP and DPP advocate for economic stimulus via tax cuts and fiscal spending. Their policy stances could keep the LDP and CDP in check, as they have advocated for increased fiscal prudence in the form of corporate/financial income tax increases. Thus, all three scenarios likely imply relatively expansionary fiscal outcomes that could be supportive for the economy. All parties are also supportive of increased domestic semiconductor manufacturing.
The risk scenario is that the CDP manages to take power and implements their economic agenda, in turn jeopardizing Japan’s reflation progress. The CDP has called for targeting 0% inflation and greater fiscal prudence, both of which would be restrictive to domestic growth and would almost certainly reverse the reflation progress to date. We view this scenario as a smaller tail risk, as the LDP has by far the most votes and the CDP would have to gather support from a patchwork of smaller political parties including the IP and DPP, in order to gain power. These latter two parties both fundamentally disagree with the CDP’s policy positions.
Does this change our equity outlook?
We retain our constructive view on Japanese equities, predicated on sustainable domestic reflation from a macro perspective, and corporate governance reform from the micro angle. In most scenarios, a likely outcome from a domestic policy perspective is supportive fiscal spending in the form of subsidies to consumers, and potentially even income and sales tax cuts. Furthermore, we do not view the monetary policy reaction function to have meaningfully changed.
The Japanese earnings season is also about to begin. Earnings revisions have been positive, and the recent weakening in the yen, if sustained, offer upside earnings risk. In addition, this is the fiscal first-half earnings season where additional shareholder returns in the form of buybacks are typically considered. Buybacks are tracking up over 100% year-over-year, and we could see this trend continue in the weeks ahead. Foreign investor positioning in Japanese equities is also a lot cleaner than before.
AFTER A WASHOUT IN Q3 DUE TO THE UNWINDING OF YEN CARRY TRADES, FOREIGN POSITIONING IN JAPANESE EQUITIES IS CLEANER
Foreign securities investment into Japan stocks, net flows USD billions
The bar chart shows the net flows of foreign securities investment into Japanese stocks in billions of USD from 2014 to 2024. From 2014 to 2023, we can see that net flows into Japanese securities have varied greatly year over year. In 2014, we saw net inflows of 24.5 billion USD. In 2015, net inflows totaled 1 billion USD. In 2016, there were 38.7 billion USD net outflows. In 2017, there were net inflows of 4.4 billion USD. In 2018, there were 54.7 billion USD net outflows. In 2019, there were net inflows of 11 billion USD. In 2020, there were 63.7 billion USD net outflows. In 2021, there were net inflows of 34.4 billion USD. In 2022, there were 11.9 billion USD net outflows. In 2023, there were net inflows of 26.4 billion USD. In 2024, Q1 and Q2 both saw net inflows of 10.4 billion USD and 25.4 billion USD, respectively. In Q3, however, the market saw 45 billion USD of net outflows due to the unwinding of the yen carry trade. After the unwind, however, investors returned to the Japanese market. The Japanese equity market saw 20.4 billion USD of net inflows in October 2024.
With recent corporate earnings revisions remaining positive, tailwinds from recent JPY weakness, potential upside from greater cash returns to shareholders, and a near-record valuation discount to U.S. equities, we find the risk/reward for Japanese equities attractive.
How could the U.S. elections impact Japan?
We think a potentially larger and more immediate risk on the horizon is the upcoming U.S. elections. A key risk to watch is trade: in a downside risk scenario, tariffs on Japan may have some direct negative impact. An escalation of U.S.-China tensions could also cause some negative spillover to Japan’s growth through the trade channel. It is widely expected that under a Trump presidency, a blanket 10% tariff – excluding China, which could see 60% – on all goods imported into the U.S. will likely be imposed. The actual impact will likely vary depending on the possibilities for transshipments or exemptions. A sizeable share of Japan’s exports to China (3% of Japan’s GDP) is increasingly consumed within China rather than re-exported, so disruptions from U.S.-China trade tensions may be limited, though risks remain given the difficulties in measuring the economic impact of trade tensions.
While a Harris victory is likely neutral for Japanese equities, we see greater ramifications in the event of a Trump presidency, and furthermore, if there is a Republican sweep. At the TOPIX level, we estimate that exports to the U.S. represent ~15% of sales with the corresponding earnings impact from a 10% tariff at around -2%. Offsetting this, Japanese companies have been localizing production for the last 30+ years, so the net impact could be smaller.
A potentially positive outcome under this scenario is that USDJPY could remain somewhat elevated relative to our current mid-2025 outlook of 138-142. In the event of a Republican sweep, USDJPY may move higher than today’s ~153 level, at least in the short-term, providing more tailwinds for equities. So overall, a Trump win (and Republican sweep) is a relatively positive outcome for Japanese equities.
However, the JPY may also weaken to politically unacceptable levels, compelling policymakers to pressure the BoJ or conduct verbal intervention, while keeping in mind that an excessively strong JPY is also a negative for the economy. Increased volatility in the currency pair is likely, but we continue to see a gradually stronger yen on narrowing rate differentials in the medium-term, as U.S. rate cuts proceed. JPY hedging is not necessary for longer-term Japanese equity positions.
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Index definitions:
The TOPIX, also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange. The index is supplemented by the subindices of the 33 industry sectors.
