We've been watching Japan closely over recent months, and after digesting the data our outlook has gone from positive to neutral. Here's why.
By some measures, the Japanese economy has been producing more than its relatively scarce resources can sustain in the long-term, a situation referred to by economists as a 'positive output gap'.
This could be a catalyst for consumers and businesses to spend and invest, but to do that, both sectors of the economy need to expect jobs to remain plentiful and well-paid for a long time. Otherwise instead of spending, they’ll save.
We believe the spending will occur, and Japan’s growth will shift to a structurally stronger level. But we also acknowledge an increased risk that both consumers and businesses may end up saving the near-term gains, and that the domestic economy will remain stuck in the doldrums.
An indicator of spending/investment stability is the difference between an economy’s growth and the rate of interest paid for taking no risk.
In the long-term, if an economy grows more strongly than the risk-free payout, the benefits should go to takers of risk. If the economy pays risk-takers less than those taking no risk, nobody will take any risk and the economy will tend to spiral towards very low levels of dynamism.
What the data tells us
Like most equities, Japanese stocks have done well so far in 2019. Recent moves have hardly posted big gains, but when you factor in the disappointing newsflow, it is interesting that equities managed to hold their ground.
On the data front, we have seen disappointing releases and revisions. Trade data from March showed 2.4 per cent year-on-year growth in Japanese exports, below the 2.6 per cent figure expected by economists.
Imports were even more disappointing, growing just 1.1 per cent against expectations of 2.8 per cent and well below the revised 6.6 per cent figure for February.
Industrial production for February was also revised down to 0.7 per cent from an initial 1 per cent reading. When you combine this with the disappointing business sentiment surveys released a few weeks ago, overall Japan is looking lethargic.
As well as the dreary data, it was revealed that the Bank of Japan (BoJ) will become the largest owner of Tokyo-listed shares by next year.
According to Nikkei calculations, at current pace the BoJ’s quantitative and qualitative easing (QQE) programme will see them overtake a large government pension fund to become the country’s largest holder of exchange-traded funds.
This raises serious concerns for the central bank. It may be distorting the make-up of Japan’s equity market, and may also mean the BoJ won't be left with much in the tank to boost a stalling economy.
Despite this, equities have managed to nudge higher. This was likely more to do with China than it was Japan itself.
The Chinese economy grew 6.4 per cent year-on-year in Q1, beating expectations. This, coupled with improvements in industrial production, fixed-asset investment and retail sales, has supported recent investor optimism around China, showing the government’s fiscal stimuli are working.
That is good news for Japanese exporters, who were hurt by China’s economic slowdown after coming to rely on their fast-growing neighbours.
Shifting our position
We have been relatively positive on Japan for a while. The global slowdown emanating from China meant Japan was well-placed to take advantage of the expected economic recovery this year. The Chinese fiscal stimulus package and a rebound in global risk sentiment made Japanese stocks look attractive.
However, recent developments have caused us to reconsider this position.
Economic activity in Japan this year has been slower than we expected, even after the meagre 0.7 per cent growth managed last year.
But the problem is the BoJ has already exhausted most of the policy options at its disposal.
It’s a similar problem facing the European Central Bank (ECB). With both short and long-term interest rates so low, bank profits take a huge hit, as banks cannot realistically offer customers interest rates below zero as otherwise they would just decide to hold cash.
In the European case, this problem is compounded by a political one: The decision-making structure within the eurozone makes it harder for the ECB to take effective measures.
The BoJ doesn't have this problem. But in Japan, the economic fundamentals are arguably worse.
With GDP growth so low, there isn't much of a gap between long-term interest rates and growth. And with such high levels of debt (particularly government debt) this means the incentive to spend and invest is much lower. The economy just isn’t offering a high enough return.
What makes the situation worse is the low growth problem is a long-term structural one, due in large part to Japan’s ageing demographic. The native population declined by 430,000 last year alone.
That is why the BoJ have had to resort to a more radical QQE than anyone else – buying not just government or corporate bonds but equities too.
The bank’s unprecedented policy measures have undoubtedly helped to support the economy and financial system, but the fact that low growth and weak demand persists shows that more needs to be done. The problem is it’s not clear what more can be done.
However, while we are no longer as positive on Japan, that is not to say we have become outright negative.
Japan’s long-term structural problems are well known, so their equities are priced accordingly. That is why Japanese stocks have some of the best valuations around, with QQE causing a wide spread between equity returns and bond yields. That means there is still value to be found.
But the risk is what happens if global and Chinese growth does not rebound. Japan, with its already meagre growth and weak internal demand, could lose out. The recent weaker-than-expected data out of Japan makes that risk more likely.
We are not pessimistic about Japan’s prospects this year, but our optimism has faded.