At regular asset allocation meetings a decade or so ago a battle-scarred friend always said the same thing when asked for his views on regional equity strategy: It’s never too late to underweight Japan.
Abenomics changed all that, making Japan the star performer of 2013 and 2014. Yen strength has blown Japan somewhat of course lately but next month could see a rebooting of a deflation-busting policy mix that may provide a blueprint for the UK in the post-Brexit world.
Since its property and stockmarket bubble burst in spectacular fashion in 1990, Japan became a money losing machine like no other. The Nikkei index fell from almost 40,000 at the start of that year to 8,500 22 years later. Over that time, Japan had changed from a world-beating economic powerhouse boasting the largest and most liquid stockmarket on the planet to a shadow of its former self, stuck in a deflationary trap with debt spiralling higher and the economy barely growing.
In December 2012, Prime Minister Shinzo Abe set out to break the deflationary mindset and inflate away the debt burden through his “three arrows”: monetary ease, responsive fiscal policy and structural reform. Since then sterling-based investors have seen their Japanese investments double in value, handsomely outstripping the FTSE100. Abenomics is starting to look tired, however. Japanese growth remains sluggish and yen strength over the last year has seen a move back towards deflation.
Initially, Abenomics met with success with monetary ease to weaken the yen and boost the stockmarket, and upfront fiscal stimulus to get the economy moving. The third arrow, structural reform, is harder to measure. But there have been a wide range of eye-catching policies aimed at boosting trend growth and making the economy more productive, from encouraging higher female participation in the workforce to the creation of the JSX400 stockmarket index to steer capital towards the most profitable and investor-friendly companies.
However, the initial recovery faltered when the second arrow changed direction. Pressure from the Ministry of Finance turned what started out as fiscal stimulus into a misplaced attempt to balance the books via a 2014 rise in the sales tax. The initial impact of monetary easing also lost its force, allowing yen strength to act as a headwind on the economy.
The time is ripe to revisit the initial successes. Strong parliamentary backing in recent elections offers Abe an opportunity to reboot Abenomics, while taking advantage of abnormally low, even negative, government bond yields. The government is in effect being paid to borrow and spend and that is what we expect them to do.
The Bank of Japan has said it will unveil a comprehensive review of monetary policy at its September meeting, which may prompt more quantitative easing measures and possibly another rate cut to pull the first negative base rate in a developed economy even further under water. Meanwhile, we expect the traditional independence that defined the BoJ during the 90s to switch to a more cooperative line, exploiting synergies between fiscal and monetary policy – perhaps a raft of government-backed infrastructure bonds bought by the BoJ at negative yields.
With this in mind, our outlook for Japan continues to be optimistic and we may seek to increase our overweight positions in Japanese equities if policy comes through with sufficient force. The widening gulf between the BoJ and a US Federal Reserve itching to raise rates should weaken the yen furthe. And with the exchange rate closer to 100 than 120 versus the dollar, we do not expect political pressure from America to limit the potential for Japan to devalue if coupled with domestic stimulus measures. A weaker currency should drive a return to inflation and have a positive impact on the stockmarket. The beneficial effect on company profits, particularly for exporters, should lead to a return to nominal wage growth, providing workers with the cash needed to boost consumer spending.
Britain could learn a lot from what Japan does next. Japan suffered its bubble burst a generation before the global financial crisis. Arguably, we are all Japan today. Interest rates are close to zero and governments are unsure if they should pursue austerity policies to cut debt levels or borrow to invest and stimulate the economy. Abe is the first G7 leader to realise the potential for low-cost stimulus and if nominal growth recovers as we expect, then government investment in the economy will pay off through higher tax revenues.
Policy makers at home and abroad will watch Japan’s responses to its deep-seated problems with interest. Its adventurous combination of monetary and fiscal policy will offer a trial run for what will work, and what may fail, to combat the forces which will shape many economies of the future.
Trevor Greetham is head of multi-asset at Royal London Asset Management