Since our October 31 commentary, “Japan Equities as the BOJ Puts on a Full-Court Press,” Japan unexpectedly reported that its economy has fallen into recession, with GDP declining 0.4% in the third quarter, following a 1.9% drop in the second quarter. Some commentators then declared that Abenomics, the government and the central bank’s program to stimulate growth and end years of deflation, is evidently a failure. We think that judgment is premature. The contraction in the second and third quarter appears to have been caused by consumers’ stronger-than-anticipated reaction to the increase in the sales tax. Price growth has stabilized at around 1%; the yen has weakened substantially (another objective of Abenomics); employment is full; and corporate profits are very strong. What is lacking thus far is wage growth. Real wages (wage growth corrected for inflation) have been falling for the last 16 months. This is restricting consumer behavior. Also, companies are still hoarding cash, waiting to be convinced that sustainable economic growth is at hand.
Headwind Removed
Shortly after the third-quarter economic activity decline was reported, Prime Minister Shinzo Abe announced that the planned sales-tax increase scheduled for next year would be postponed for 18 months. That delay removes a significant headwind for 2015. Also, Abe called a snap election for this month. He hopes to be able to strengthen his mandate to carry out needed reforms. In view of the weak opposition he faces, that gamble looks to be a wise one, though not completely free of risk.
Industrial output in October surprised on the upside, +0.2% over the previous month, whereas the consensus was for a 0.6% decline. Overall household spending was up 0.9% following a 1.5% increase in September – welcome but still very modest advances. The just-reported 5.5% increase in capital expenditures in the third quarter means the GDP figure for the quarter will be revised upward, possibly to zero percent growth. Looking forward, export growth in 2015 will be helped by the US economic recovery and a weaker yen. Analysis by our friends at Applied Global Macro Research indicates that the manufacturing cycle in Japan, now emerging from a bottom, should strengthen in a meaningful way in the first half of the year. Declining oil prices will continue to put downward pressure on Japan’s inflation and may lead to further stimulus moves in the new year. Calendar-year economic growth now looks likely to come in at 0.3%, accelerating to 0.9% in 2015 and 2% in 2016.
Near-Term-Long-term
The near-term prospects for the Japanese economy and markets look quite positive. However, significant longer-term risks remain. The stock of gross debt, now equal to about 230% of GDP, needs to be addressed. Demographic trends are severely limiting Japan’s potential long-term growth rate, and the economic reforms that could ease this constraint remain uncertain. Moody’s downgrade of Japan to A1, still investment grade, following the earlier similar move by Fitch, reflects medium and longer term concerns about the debt situation. There was little discernible effect on the bond market where yields fell in the day following the news.
Despite the technical recession in the economy (two quarters of declining GDP), Japanese equities have moved from dismal performance in the first half to outperformance in the second half. The iShares MSCI Japan (MX:EWJ) equity index is up +9.08% year-to-date in local currency terms. That compares with +4.32% for the iShares MSCI Eafe Index Fund (ARCA:EFA) Index that covers all advanced economy markets outside of North America and +3.56% for the MSCI Europe Source (XETRA:SMSEUR) Index. The importance of using a hedged ETF to access the Japanese market is clear from the market’s performance in US Dollar terms, down -3.10% year-to-date, as the decline in the yen versus the US dollar more than wiped out the market’s advance in the domestic currency. The yen is likely to ease further against a still-strengthening US dollar in 2015.
Underlying the recent advance in Japanese equities, the Japanese corporate sector had a strong third quarter, with profits advancing 21%. Earnings per share are projected to grow by 22% in fiscal year 2015, following a 12.5% advance in fiscal year 2014. Valuations remain attractive relative to those in the US and Europe.
Bill Witherell, Chief Global Economist