NN IP: Big in Japan

Political risk in Japan is low

Even though Japan has never seen the kind of populism seen in Europe and the US, political uncertainty did increase substantially in Japan in the run up to the elections. The reason was that Abenomics can be seen as an experiment. While this experiment fits perfectly within the prevailing constitutional, international and social constraints in Japan (after all it is about tactical policy setting) it also elicits a lot of political opposition. Abe’s opponents saw a chance to topple him from power but Abe outsmarted them by calling snap elections. The price he could have had to pay for that was a loss of a 2/3 majority in the Lower House in which case he would have had to abandon the Constitutional reforms. Still, in this case the gamble paid off and Abe can have his political cake and eat it, i.e. Abe’s political capital is replenished and he can pursue Constitutional reform. The practical implication for investors is that they will be able to enjoy an unusual degree of certainty about the Japanese policy mix for the foreseeable future with the risks skewed in the direction of more rather than less demand side stimulus or potential growth enhancing reforms. Perhaps the outcome is not all that surprising with hindsight because a recent survey of the Cabinet Office in Japan reveals that 73.9% of the population is satisfied with their overall life which is the highest number since 1995. Also for the first time since the mid 1990’s more than 50% is satisfied with their income conditions. All this can be seen as evidence that Abenomics is slowly but surely changing the psychology of the Japanese population in a more positive direction and voters decided to reward Abe for that. 

Japan is currently at a pretty crucial phase in its reflation cycle. In a sense it is all or nothing from this point on, i.e. either nominal GDP reaches escape velocity, which will push it on a sustained upward sloping path consistent with 2% inflation on average in the long run, or nominal GDP will fall back to the more or less sideways to slightly declining trend seen in the 15 years before Abe came to power. 

Because all financial assets (except for money) are a claim on future nominal GDP the stakes are pretty high for investors in Japanese assets. Over the past two years growth has been pretty broad based across sectors and demand components. Export growth has been picking up strongly since early 2016 on the back of the acceleration in global growth, while private domestic demand is underpinned by both consumer spending and capex. In this respect, Japan also has its own version of a positive feedback loop between domestic spending and income. The business sector is clearly in an expansionary mode as capex growth remains on an uptrend while employment growth continues to be solid. Strong profit growth as well as improving business confidence serves as an important underpinning for this. Meanwhile, the household sector benefits from rising labour income growth and rising consumer confidence suggests a willingness to spend a large chunk of this. Last but not least, the economy has benefited from a sizeable fiscal stimulus over the past few quarters while monetary policy has been very helpful in keeping borrowing costs down and preventing the yen from appreciating. All in all, it seems the economy should be able to maintain a growth rate of around 1.5% or perhaps somewhat more in the foreseeable future in the absence of a negative shock. 

The advantage of running a high pressure economy

Another potential show stopper could be the fact that the Japanese economy will run into hard supply constraints. If this happens, there will be some mechanism which forces demand growth to slow down. This could either be an erosion of profit margins if businesses cannot pass rising unit labour cost growth on to end consumers, or it could be monetary tightening. However, the story of Japan so far shows there is also an alternative which does not involve a slowdown in growth, even though the labour market may well be overheating. The job-to-applicant ratio is at the highest level since 1974 while the unemployment rate stands at 2.8%, which is the lowest level since the early 1990s. It must be said that in the 1960s and 70s the unemployment rate fluctuated in the 1-2% range while in the 1980s it was in the 2-3% range. Hence, from a long historical perspective 2.8% is not very low. We see the same phenomenon in other countries. One reason could be that labour markets were more flexible (e.g. worker protection was much less) which caused the NAIRU to be lower. At any rate, 2.8% in Japan is widely thought to be somewhat below the NAIRU and the fact that the labour market is overheating is supported by circumstantial evidence such as the afore-mentioned job-to-applicants ratio as well as survey evidence on labour shortages. In this respect, it is worth mentioning that the unemployment rate would have fallen a lot more if it had not been for an increase in labour supply. The participation rate has been on a declining trend since the mid-1990s due to population ageing, but since Abenomics started 5 years ago it has increased by 1.5pp on balance. This is mainly the result of an increase in female and elderly participation. In this respect, Japan provides a clear example that “running a high pressure economy” can expand the supply side.

Yet despite the tight labour market, the response of wage growth remains disappointing but not completely so. Around 30% of all workers are on hourly contracts which can be varied easily by their employers. Giving them a wage increase is thus not very risky because in a slump employers can easily cut back the number of hours worked. Their wages are rising at a 2.5% rate which is pretty decent and close to being consistent with the 2% inflation target. Still the other 70% of the work force are on permanent contracts and their wage setting will depend on the long-term outlook for growth, the yen, fiscal sustainability, trade relations etc. After all, their bosses cannot cut back their hours or fire them easily. Wage growth for these workers remains below 1% on balance. Still, labour shortages are also affecting this group but instead of raising wages, employers seem to prefer raising investment in labour-saving technology instead. This has the beneficial effect of raising productivity growth, even though this comes at the expense of a delay in the convergence of inflation towards the target. Yet again, this is an example of how the combination of a high pressure economy and lowflation expectations can lead to a positive supply side response. In a sense, this high pressure economy can at least partly accomplish the goal of structural reforms which is to move resources towards high productivity sectors and business.

In an ideal world, this process would be complemented and enhanced with ongoing structural reforms. Still, these are usually politically contentious and even though the LDP has a 2/3 majority there are probably divisions within Abe’s party. One of the proposals on the table is to try and achieve 3% wage growth next year by giving companies tax incentives to raise wages. This has been tried before over the past few years and with only limited success. The reason is probably that profits do not form a real constraint for wage growth because they are at very healthy levels already and have been rising over the past year. The real constraint is lowflation expectations, perhaps coupled with uncertainty about trade relations or geo-political risks. Also there is talk about reducing the corporate tax rate. As we argued in the case of the US, in theory this should raise wages because of the added incentive for investment which raises the amount of capital per worker and thus labour productivity. In practice this mechanism, if it is operative, would trigger a capital inflow which would cause the yen to appreciate. What’s more, it may well work to some extent in a small open economy which is well behind the technology frontier such as Ireland in the late 1980s, but the effects in a large economy are probably relatively small. At any rate, corporate profits are already high and to a considerable extent they end up as cash holdings on the asset side of the corporate balance sheet. As a result, a corporate tax cut will not alter the incentive to invest much. Also, the aim of the tax cut is already being achieved by the corporate response to labour shortages so it would be better to focus fiscal stimulus on other activities. One of the initiatives in this respect is making education and pre-school provision for very young children free which should help to raise female labour supply further.

Sweet spot for Japanese risk assets

One feature which may be underappreciated by investors and commentators is that the combination of lowflation expectations which are more sticky than expected and an expanding supply (productivity) side presents a pretty good scenario for investors. Of course, in the end, achieving sustained nominal reflation will be all important but a bit of a delay is not a bad thing if it pushes the real part of the equation onto a permanently higher path (once again just as long as the nominal side converges to sustained 2% inflation eventually). Higher future nominal GDP will be a positive for risky assets and this trend will be enhanced by the expectation that the combination of monetary and fiscal stimulus will need to be around for a bit longer than perhaps previously thought. What’s more, the degree of uncertainty about this policy outlook is very low compared to other DM economies. In all this, we have the most confidence in the continuation of the BoJ’s easy monetary policy stance. Abe has been making some complimentary noises about Kuroda so it seems he will be reappointed as BoJ Governor. As a result, investors can be assured that the big positive demand shock leverage machine/grand invitation to more fiscal easing device otherwise known as Yield Curve Control will remain in place.

This was very much the message from the October BoJ meeting. If anything the stickiness of lowflation suggests the risks are tilted towards the 10-year yield target remaining on hold until sometime in 2019. We believe that the BoJ will start to increase it once underlying inflation reaches 1% on various metrics, because that will mean that real rates will be pushed down to -1% (the level currently prevailing in Europe now) which is where the BoJ will want to keep them for a long time to achieve a sustained albeit moderate inflation overshoot. Some pundits question the feasibility of this strategy. Of course, in the very long run keeping rates at zero will become a problem because at some point that will not be consistent with the goal of monetary policy (2% inflation target). The credibility constraint on the 10-year target is thus that it must be consistent with the future path of the policy rate needed to achieve a temporary overshoot of the inflation target plus a term premium (which is also driven by foreign developments). If the credibility diminishes this will first show up as a rise in inflation expectations, which would of course be very welcome! Apart from all this, the BoJ kept the JPY 80 trillion “reference number” for JGB purchases but it is clear that the meaning of this is purely symbolical as it will satisfy the monetarists on the Board (one of whom would like to see an increase in purchases). If you target the price in a liquid market you cannot target the quantity at the same time and the actual pace of purchases is currently a little more than half the reference number.

Finally, the outlook for fiscal policy is a bit less certain than for monetary policy. In particular the 2019 VAT hike could be problematic, even though our base case is that it will be smoothed over by additional fiscal easing. What’s more, in two years’ time nominal GDP is likely to have gained significantly more momentum relative to 2014 (previous VAT hike), all the more so because it is close to the 2020 Olympics. Apart from this, it will be crucial that Abe postpones the date at which he seeks to achieve a primary balanced budget well into the 2020s.

Emerging markets: resilient growth

Despite the recent nervousness in emerging markets, linked to the shift in Fed expectations since September, EM growth data is holding up well. It is still too early days to see a meaningful impact of higher EM bond yields on EM credit growth, let alone on consumption and corporate investments. Between mid-September and mid-November, EM bond yields have risen by some 30 bps on average. This is still substantially less than the widening of 50 bps the same time last year, around the Trump election shock.

Our own measure of EM financial conditions has come down since September, but remains in dark-green territory, suggesting that EM credit growth can continue its steady recovery. The most timely credit data, for the last few weeks, do not show a weakening in momentum. This, in combination with the still solid global trade data and the good Chinese consumption growth, keeps us confident that the EM growth recovery, which started in the summer of 2016, will continue.

The recent improvement in our own EM growth momentum indicator suggests that we need to see a much sharper uptick in EM yields before getting worried about the short-to-medium-term EM growth prospects. This could happen in case of a miraculous passing of a ground breaking US tax reform or if Trump would appoint several hawkish Fed governors. For now, this remains a risk scenario.