Japan Update: Abenomics Still Broadly On Track

Seeing no need to augment its already very expansive program of quantitative easing, the Bank of Japan (BOJ) concluded its October 3-4 Monetary Policy Meeting by deciding to keep policy unchanged. It characterized the Japanese economy as “starting to recover moderately.” That “moderate” recovery entailed GDP growth at an annual rate of 4% in the first half of 2013 – that is, more than twice the 1.8% GDP growth rate for the US, not to mention more than ten times the barely positive (0.3%) rate for the Eurozone. Following years of deflation, the BOJ was probably also encouraged by the acceleration of the core consumer price index to +0.8% in August, a meaningful step towards its 2% inflation target. Even more encouraging was the BOJ’s quarterly Tankan survey, which indicated that the measure of business confidence for medium and large firms has now reached a six-year high.

Earlier in the week, Japan’s prime minister, Shinzo Abe, felt sufficiently confident in the recovery’s progress to confirm that his government will press ahead next year with the country’s first increase in the sales tax in 15 years. The move was deemed necessary in light of the nation’s having the highest gross debt-to-GDP ratio among the developed economies. Abe is trying to balance achieving needed fiscal consolidation with maintaining the economic recovery. He stated, correctly in our view, that the tax increase will be necessary “to maintain faith in the country and to pass on a sustainable social security system to the next generation.”

As part of his balancing act, Abe announced plans to partially offset the effects of the tax increase with a 5 trillion yen fiscal stimulus package. Possible components include tax relief for homebuyers and early repeal of an existing surcharge on corporate income tax. Should this stimulus start to look inadequate and the recovery show signs of faltering, there is little doubt that Abe would move to increase the stimulus in conjunction with the BOJ’s further expanding its program of quantitative easing. The strong political consensus now behind Abe will likely be reflected in market sentiment buoyed by positive expectations. He is delivering what he promised. His next challenge will be his package of structural reforms, which will be unveiled in the near future.

An important effect of the rise in inflation, coupled with the BOJ’s program of buying government bonds and driving interest rates down, is that Japan’s long-term real interest rate, the yield on long-term government bonds (corrected for inflation), has become negative. This is a result sought by Abe’s attack on deflation. Investors are expected to seek higher returns elsewhere, through Japanese equities and mortgages or through buying foreign assets. The latter would encourage further depreciation of the yen, which has been trending in the other direction – that is, appreciating versus the US dollar – since early July.

The dramatic recovery in Japan’ s equity market slowed substantially in the third quarter, with the MSCI index for Japan achieving a gain of only 6%, compared with the 10.9% gain for the MCSI EAFE Index for developed markets outside of North America and the 5.2% gain for MSCI USA (total market). Over the past month, the largest Japan ETF, iShares MSCI Japan, is up 3.6%. This increase was due mostly to the appreciation of the yen, as can be seen from the +0.56% one-month performance of the WisdomTree Japan Hedged Equity Fund ETF, DXJ, which is hedged against changes in the yen-US dollar exchange rate. On a year-to-date basis, DXJ, at 28.81%, is still outperforming EWJ, at 20.15%. We anticipate that the yen will return to further depreciation versus the dollar in the coming months, as Abe’s and the BOJ’s policies proceed and the US dollar eventually firms towards year-end and into 2014.

BY Bill Witherell