J-Money: After Snap Election, has Abenomics Worked?

J-Money, February 2015

The final quarter of 2014 was a lively time for Japan. There was renewed monetary stimulus from the Bank of Japan – unexpected, by most of the world; the dissolution of the lower house followed by a snap election in December, through which the ruling coalition won a new two-thirds majority, apparently endorsing Prime Minister Shinzo Abe and his economic policy; there was a delay to the second phase of the planned increase in VAT; and, in the background, a continuing contraction of the Japanese economy despite the many efforts to rejuvenate it.

By late November, by which time the election had been announced but not yet completed, it looked like the shake-up had worked. Between October 21 and November 21, Japanese equities rallied 17% and the yen depreciated 10% against the dollar – which is what Abe and the Bank of Japan want it to do.

But performance since then has been mixed, and international analysts and fund managers are still unsure whether Abenomics – either the recent measures or the whole two-year programme to date – have been a success.

“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,” says Michael Stanes, investment director at Heartwood Investment Management. “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,” Stanes says, “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.”

Stanes’s view – that yen weakness is only a piece of the jigsaw, and that broader structural reform is still needed – is common among western investors. They accept that Abe is reform-minded, and that others are too, but believe that making fundamental change is still problematic because of vested interests in Japan. Viewed from the west, it seems that the snap election in December was Prime Minister Abe seeking a renewed vote of confidence for his reform agenda, and he got it; but still, further reform is necessary. Stanes calls for the deregulation of the Japanese industrial and services sectors, opening economic borders to foreign competition, reforming the agricultural sector, and liberalising immigration laws in order to address the structural decline in the working age population. In the meantime, Heartwood, for one, is neutral on Japanese equities, with Stanes concluding: “The risk is that politicians will once again disappoint investors.”

In this context, the decision to delay the VAT hike was closely watched. “Japan watchers are split on the implications of delaying the tax,” says Chris Wehbe, global market strategist at Alquity Investment Management in London. “Adam Posen [President of the Peterson Institute, and former Bank of England member] has said a decision to ‘postpone, let alone cancel, runs a real risk of crashing the stock market’ on the basis that it is necessary to face up to the country’s fiscal situation. Others, such as Paul Krugman [an American economist and Professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University], argue Japan needs to break from deflation first and that the impact of delay is trivial.”

“Perhaps,” Wehbe says, “it doesn’t matter either way – the only way out for Japan is monetization.”

From a currency perspective, Abenomics is clearly working. In January 2013, a dollar bought just over 85 yen; at the time of writing, it buys 122. The yen hasn’t been this weak since 2007 – and, unlike then, when it was a function of financial crisis in the US and then the world, this time it’s absolutely intentional. For exporters in particular, that is a vital transition, helping to improve the margins of many Japanese businesses.

Other investors are trying to work out what Japanese economic reform means for the performance of the stock market. “A valuation of 14 times earnings is not especially cheap,” notes State Street Global Advisors in its investment outlook publication for 2015. “Japanese corporate profitability has paled in comparison to international peers for many years, but it would seem the current administration is committed to closing the gap.” State Street argues that, based on return on equity, Japanese companies have consistently underperformed their global peers, partly because of high levels of Japanese corporate tax; the recent cut in that tax rate, coupled with a weaker yen helping exports, perhaps gives reason for optimism about the relative performance of Japanese shares.

Standard Life is an example of a fund manager taking this positive view. “Within stock markets, the US, Japan, Europe and the UK are more favoured as corporate earnings prospects are favourable,” says Andrew Milligan, head of global strategy. “Structural reforms remain outstanding but a growing management focus on return on equity, and plans to cut corporation tax, are supportive, while the Bank of Japan should eventually take more action to reach its inflation target.” Standard Life has a heavy allocation towards Japanese equities (though it is light on Japanese bonds, reasoning that the inflation outlook is deteriorating). The British private bank Coutts, too, notes in its investment outlook for 2014: “Japan has a new equity benchmark with a focus on shareholder value, which could set the standard for better returns.”

Even so, the broader economy is not doing what it was supposed to under Abenomics. In December, third quarter economic figures were revised to show that Japan shrunk more than expected, contracting by 1.9% in annual terms, rather than 1.6% as originally expected. Even without the revision, the third quarter decline had put Japan into technical recession, following a 7.3% contraction in the second quarter. This is part of the reason the country’s sales tax, which had been raised from 5% to 8% in April, was not raised again as planned.

Commentators understand the reasons for this: the tax increase is necessary in order to reduce Japan’s enormous public debt, and will inevitably hit the economy in the meantime. But people have a limited tolerance for recession, and there is a growing sense that there is limited time for Abenomics to prove itself. “Prime Minister Shinzo Abe’s landslide election victory has given him a fresh mandate – and likely a last chance – to implement Abenomics, which hangs in the balance,” says Rob Subbaraman, Asia economist at Nomura in Singapore. The ultimate success or failure of Abenomics will have consequences far beyond Japan: Asia, in particular, is affected by it, benefiting from its successes and being hurt by its potential failures. But ultimately it will be the Japanese electorate that decides whether it will continue to support Abenomics and the difficult transitions it involves. The December election shows he still has the faith of the people – for now.