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The triumph of Abenomics

Japan posted growth of 1.5% in the first half of the year, which is a remarkable performance for an economy with estimated potential of no more than 1%. Expansion in the Japanese economy is propelled by all drivers of private demand: exports, productive investment, household spending.

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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.

Raphaël Gallardo , November 2017

Article also available in : English EN | français FR

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