Abenomics and the land of the rising equity market

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It’s hard to believe but the long ailing Japanese equity market has been among the best performing in the world since late last year – thanks to a jot of confidence produced by a raft of radical new reforms under Prime Minister Shinzo Abe, who was elected to office in December last year under a landside of popular support.

Dubbed “Abenomics”, the new Prime Minister’s vision is that of massive fiscal and monetary stimulus, backed up by radical structural reforms to improve the competitiveness of the economy. To that end, Abe unveiled new fiscal stimulus spending – largely on infrastructure – equal to around $100 billion, or almost 2% of Japan’s near $6 trillion economy.

On top of this, newly installed bank of Japan Governor Haruhiko Kuroda – chosen as he was sympathetic to Abe’s aims – announced an explicit 2% inflation target, which he aims to achieve by 2015. To that end, the Bank of Japan (BOJ) has unveiled the mother-of-all monetary stimulus programs, with plans to double the country’s monetary base over two years. That amounts to buying up government bonds – and pumping out cash – equivalent to around one quarter of nominal national output over this period. Relative to GDP, that’s roughly double the monetary stimulus program unveiled by the United States Federal Reserve.

Reality check

The market’s initial reaction was one of jubilation. Up to its recent peak in late May, the Nikkei 225 index has surged by 80% since mid-November last year. The yen dropped 20% in value against the US dollar, and 10-year government bond yield dropped from around 0.8% through last year, to a recent low of 0.44% in April.

Adding to the optimism, Japan recorded fairly strong 4% annualised growth in the March quarter, thanks largely to a bounce back in spending by more confident households.

Since around late May, however, somewhat of a reality check has set in. The Nikkei has dropped back 20%, and the yen has strengthened by 5%. Why?

Some correction after such a fierce market move is inevitable. And perhaps staggered by the ferocious market reactions they unleashed, some policy makers have been trying to temper expectations. A few conservative and independently minded Bank of Japan board members, for example, have expressed concerns about the stimulus program and emphasised its “temporary” nature.

Even worse, Abe’s hotly anticipated recent announcement of structural reforms greatly disappointed. Although Japan desperately needs to deregulate its labour market (firms can’t easily fire workers), and improve efficiencies in areas such as health and agriculture, Abe shied away from announcing radical proposals – and instead unveiled a re-run of an old (dubious) policy to create a special economic zone of lighter taxation and regulation. Many are hoping his reticence reflected a concern not to upset voters ahead of a critical upper house election in July, after which his ruling LDP party might have control of both legislative chambers and greater ability to push through controversial new policies.

That said, another factor unwinding some of the economic optimism has been the back up in bond yields. Japanese 10-year government bond yields have lifted back to 0.8%, or similar to levels prevailing in mid-2012. In turn, this appears to reflect a lift in inflationary expectations – understandable considered the BOJ’s aims to push inflation higher. This is a reminder that the move to drive up inflation will not be without risk, such as the potential for a surge in bond yields. That would make it more expensive for firms to borrow (at least in nominal terms) and, perhaps most critically, crush the capital value of Japanese bonds that form the vast bulk of tier 1 capital for Japan’s banking sector.

Doubts about Abenomics

Can “Abenomics” work? This economist for one has his doubts. Japan’s main problems are structural rather than cyclical – which don’t seem capable of being solved by merely printing money and building new publically funded bridges. Due to population ageing and objections to more immigration, Japan’s labour force is shrinking. And entrenched vested interests make it hard to achieve productivity-enhancing structural reforms. Lacking any real growth opportunities within the private sector, the risk is that banks simply horde cash rather than borrow, which would suit firms who see little reason to borrow to fund expansion.

What’s more, with gross public debt already more than 200% of GDP, fiscal pump priming has its limits – and may already be constraining private sector spending due to fears of an eventual lift in taxes. As it is, Japan is still committed to doubling the sales tax to 10% by 2015 to keep the fiscal deficit in check. If Japan goes ahead with the tax increases, there’s a very good chance it could derail the economy again. But if it doesn’t, its fiscal position risks becoming untenable.

Market rally ahead?

That said, over the short term at least, there’s probably scope for the market optimism to return – especially if the BOJ succeeds in pushing the yen down further, which would boost the competitiveness of its major exports. That will be easier to do if the US economy continues to recover and the Federal Reserve winds down its own stimulus program – potentially pushing up the US dollar.

At around 15 times forward earnings, Japanese equity market valuations remain a touch below their decade average and could lift further – but a sustained market rally over the next two years will require the economy and corporate earnings to pick up also.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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