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The strength of this phase of growth is due to the
fact that it is not driven by the improvement in world
trade alone, as was the case for all the Japanese
economy’s false starts over the past two decades,
but rather it is the result of synergies uniting the
three arrows of Prime Minster Shinzo Abe’s economic
program (fiscal stimulus, monetary easing, structural
reforms).
Monetary policy is based on three areas (QE,
negative policy rates and control on the yield curve)
to keep the yen weak and long-term rates low
despite a continued unsustainable budget deficit
(public debt was monetized at 45%). Reforms to the
labor market promote immigration and increase the
presence of women in the workforce, thereby
ensuring that Japanese companies maintain wide
margins despite achieving full employment with
unemployment at a mere 2.8%.
This economic policy has its limits: we are far from
the 2% inflation target, which makes the economy
vulnerable to a return to deflation in the event of an
external shock.
The improvement in public finances is
pushed back, while the ageing population points to
an erosion in the country’s external assets (currently
65% of GDP). Tax adjustment targets households via
increases to VAT, while corporation tax rates have
been severely cut from 40% to 30%, further bloating
corporate margins that are already substantial.
Lastly, incentives for financial institutions to make
their portfolios more international are a double-edged
sword: on the one hand, they could trigger
uncontrollable capital outflows in the event of a loss
of confidence in monetary policy if inflation
expectations suddenly soar; on the other hand, Japanese banks have become the largest eurodollar
lenders in the world, exposing them to a potential
squeeze on dollar liquidity (Quantitative Tightening
from the Fed).
For now, the Bank of Japan’s failure to push up
inflation expectations paradoxically safeguards from
the risk of outflow for the yen and JGB. Furthermore,
capital outflows are restricted by the renewed Japan
premium on dollar-yen forex swaps, which reduces
the appeal of US bonds once the cost of forex
hedging is factored in.
So Japanese growth is particularly robust and slanted
in favor of corporate profits (wage inertia). It is
therefore not surprising that projected earnings
growth for listed companies is more than 10%.
Valuations for Japanese equities are attractive in our
view (Price to Book of 1.4 at fair value, P/E 14x vs.
16x in our model). Lastly, the Bank of Japan
continues to buy equities via ETF (JPY6tr in three
years). We therefore overweight Japanese equities in
our multi-asset portfolios.
Risks on this position are primarily political. Japanese
growth hinges on momentum in China, but a blip in
the Chinese cycle seems improbable in the short
term with changes in the make-up of leadership
during the Communist Party Congress. However,
elections on October 22 have already had an impact
on Japanese economic policy: the emergence of a
new opposition led by the governor of Tokyo, Yuriko
Koike, forced the government to make fresh fiscal
pledges (half of the revenue derived from the hike in
VAT in 2019 will go to the education budget).
Meanwhile, geopolitical threats remain. Japan’s trade
surplus, inflated by the weak yen policy, could attract
ire from the White House, as it did during Reagan’s
Voluntary Export Restraints. Lastly, Japan is exposed
to the risk of an escalation in the North Korean crisis:
this issue is a systemic risk for all risky assets
(equities, credit), which we partly hedge via our
exposure to gold and the dollar.
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