As Prime Minister Theresa May proved earlier this year, political gambles can backfire. But this was not the case for Japan's prime minister Shinzo Abe, who last month pulled off another decisive election victory.
In a country where politicians come and go, Abe’s landslide success deserves high praise. Should he stay in office for two more years he will become Japan’s longest serving prime minister since the Second World War.
Abe’s three-pronged approach towards tackling the country's economic stagnation appears to be gaining real traction. Monetary easing, fiscal stimulus and structural reform all seem to be gradually paying off in economic terms. Now, they’re paying off politically too.
One of the general gauges for economic sentiment in Japan is the Tankan Index, which covers thousands of companies above a certain amount of capital. Recently the overall Tankan index, covering all industries and companies of all sizes, rose by three points to +15, the highest reading since September 1991.
Other indices and measures also point towards continuing economic improvement. The Japanese economy has now expanded in six straight quarters, the first period of sustained growth in more than three years. It’s also the highest rate of growth since the first quarter of 2015.
But the data also shows companies experiencing labour shortages, with the index for employment conditions weakening by three points to -28. Japan’s unemployment rate remains at just 2.8 per cent, coming down from its highest ever level of 5.5 per cent in 2002.
A juncture has been reached. Either rising wages will lead to a more self-sustained recovery, or more structural reform may be required to return Japan’s labour market to the flexibility it displayed in the past.
We expect gradual wage rises to be recorded over the coming months, perhaps further aided by public encouragement from the government that now is the time to seek better paying jobs. The public has given Abe and his government a mandate for change, but sooner or later they are likely to want this support to be repaid in the form of rising wages.
Going for growth on corporate earnings
The International Monetary Fund has stated the world economy is enjoying the broadest and fastest rate of growth since 2010.
This is on the back of finally rising business investment, which is improving longer-term economic prospects. Better global growth prospects are supported by continued low inflation across the world and low interest rates. The winding down of fiscal austerity should additionally help boost household incomes.
These are powerful tailwinds for the prospect of improving corporate earnings, which form the ultimate foundation for share valuations and thus sustainable stockmarket levels.
This year has so far been a good one for company profits. In the US, the first quarter reporting season delivered double-digit annual earnings growth of 14 per cent. This was followed three months later by another 11 per cent rise. Earnings growth was even stronger in Europe with an annual rise of 25 per cent in Q1 and 14 per cent in Q2.
Compared to these past results, consensus projections for Q3 in the US have more than halved over the past six months, from 9 per cent at the beginning of the quarter to just 2.8 per cent for the S&P500, and from 12 per cent to 6 per cent for Europe.
Ironically, these reductions actually lower the hurdle rate for companies, and make it easier to deliver positive earnings surprises. Indeed, with 43 per cent of US companies having reported by the end of October, the actual growth run-rate has already climbed back up to 6 per cent in the US.
While we expect certain sectors and companies to report a hurricane related slump in profits, with the much lower hurdle rate the inevitable positive earnings surprises could act as a positive catalyst that drives further upward momentum in equities as we head into 2018.
The recent rebound in commodity prices during Q3 could also provide support to the earnings of the energy and mining sectors. Some analysts believe the energy sector in particular could move higher, given fairly depressed relative share price performances, and with oil moving near the top of the current higher range.
Like the US, financials and commodities in Europe appear to be driving a large bulk of earnings per share (EPS) growth in 2017. But growth looks more balanced next year across multiple sectors. Industrials, staples, IT and telecoms are all predicted to post double-digit EPS expansion in 2018.
US tax reform plans
While president Donald Trump’s tax reform plans have been criticised over their lack of detail, some of the more exciting elements bear closer examination.
The proposal to abolish the system of global taxation of US subjects and change to the territorial approach practiced by the rest of the western world would mean foreign income would either be exempt from US taxation, or bear a minimum tax rate regardless of repatriation, which might be lower than the domestic statutory rate.
Global technology superstar companies like Microsoft, Google, Amazon, Facebook and Netflix have refrained from repatriating overseas earnings to avoid double taxation. If some of the retained cash positions outside the US found their way back into corporate investment, this could have another significant stimulus effect for the US economy.
According to Goldman Sachs, even without such repatriation benefits Trump’s corporate tax reduction plans alone could increase the S&P500 EPS estimate by around 10 to 12 per cent.
This all sounds very promising, but there is unfortunately a fly in the ointment here. Fiscal stimulus through tax cuts, rather than through spending such as infrastructure investment, only leads to higher investment and activity if companies and investors put the money back into capital investment, rather than just banking it.
A couple of years ago, monetary easing in the form of almost interest-free capital failed to lead to meaningful additional capital investment. Yet there is a better chance it may be different now.
Firstly, confidence levels about the return on investment in the business sector are now significantly higher. Secondly, central banks’ have already announced they will gradually remove monetary stimulus over the coming months and years.
Another interesting impact of tax reform is on market structure. Over the past decade an estimated $2trn has gone from active to passive, which means investors have increasingly bought the market as a whole, rather than picking individual names.
But because there will be clear winners and losers from tax reform, investors should benefit more from discriminating between the shares of different companies.
In the environment of gradual economic improvement, tax reform may provide the additional stimulus that turns US economic growth from ‘not too bad’ to ‘really quite good’. Perhaps in that case, there is justification for the Trump trade to truly make a return.