Econosights – The end of Japanese stagnation?

Key points

• Years of low growth and inflation are gradually turning around in Japan thanks to the slow-moving impacts of Abenomics combined with a strong global economy.
• A lift in growth and employment reforms are increasing participation in the labour market, adding to an already tight labour market. Recent wage agreements will add to inflation.
• The solid economic cycle and good corporate health is positive news for Japanese equities, which still look favourable from an investment perspective, especially relative to US shares.

Introduction

The solid uplift in Japanese GDP growth during the last year (up by 2.1% over the year to December 2017) is impressive for an economy that has been dealing with deflation and a declining population. Japanese Prime Minister Shinzo Abe has been implementing various economic policies or “Abenomics” for years to combat Japan’s low growth, low inflation environment. These policies include: stimulatory monetary policy run by the Bank of Japan (BoJ) including asset purchases (or quantitative easing), negative interest rates and a bond yield target, reforms (lifting business productivity, encouraging higher labour force participation especially from women and older workers, cutting overtime hours and higher migration from overseas) and supportive fiscal policy. The global growth upturn (which we have written about here) has also helped lift Japanese GDP. The stability in Chinese activity is particularly important for Japan because of the reliance on goods exports and tourism.

Japan’s declining population acts as a drag on headline GDP growth so it is useful to look at GDP per capita (or per person), which can be a better guide to living standards. Japan’s GDP growth per capita looks much stronger recently compared to the US and Australia (see chart below), although this wouldn’t be evident from the headline GDP.

The other major issue for Japan during recent years has been the lack of inflation. While the market may have given up on price growth in Japan, we think the signs for higher inflation are the strongest they have been for years. In this note, we look at the changing Japanese economy, as further structural reforms, monetary and fiscal easing work through the economy.

Source: Bloomberg, Reuters, AMP Capital

A broad lift in growth should continue

The improvement in Japan’s economic growth has been broad, with an increase in household consumption, business investment and export growth (see chart below) and this positive momentum is expected to continue over 2018. Japanese corporates (earnings are expected to be up by 5% in 2018 and 6% in 2019) are benefitting from positive global conditions, particularly in the manufacturing sector which is also reflected in good export performance. Government consumption growth is soft but has some upside with a decent budget plan approved in February and Abe’s decision not to pursue a surplus by 2020.

Source: Reuters, AMP Capital

Changes in the labour market

The Japanese labour market is tight. The unemployment rate is at a historical low level of 2.4%, close to record lows, and below the long-run level of 3.8%. But, the labour market has been tight for many years in Japan and this has failed to produce any decent wages inflation (the government aims for 3% annual wages growth). This is because of specific factors in the Japanese labour market including: low movement and mobility between jobs, low expectations of wage rises from employees, increased use of non-wage compensation (like equity options) and employees holding jobs for life which limits bargaining power. The chart below shows that wages growth has been averaging around zero percent for the last 20 years.

Source: Bloomberg, AMP Capital

Strong employment growth from the good economic environment is putting additional pressure on an already tight labour market, leading to some lift in wages (but at a slow pace).

Recent annual “Shunto” wage negotiations between corporates and unions have indicated supportive outcomes for wages growth across numerous manufacturing companies (with companies like Toyota and Hitachi announcing solid wage increases) and some non-manufacturing companies. Some firms are even suggesting that wage agreements are the strongest rises seen for five years. While some of these bigger corporates have negotiated wage rises by ~3% (Prime Minister’s Abe aim) or higher, wage increases are unlikely to be on the same scale for smaller companies. Nevertheless, the pressure on wages is for higher growth, towards 2% on an annual basis.

A higher inflow of part-time workers into the labour market (particularly women and older workers), see chart below, is a positive development for the labour market overall but may mean that total wage earnings (red line in chart above) which is impacted by compositional changes (i.e. changes in the full-time, part-time split) in the labour market runs below the wage index (blue line in chart above) despite a tighter labour market, so investors should be mindful of this difference.

Source: Bloomberg, AMP Capital

Inflation – finally headed up?

The Bank of Japan has an inflation target of 2% but has been missing this goal for years (see chart below) apart from the inflation spikes around 2014-2015 when the government implemented a domestic consumption tax.

Source: Bloomberg, Reuters, AMP Capital

Stronger wages growth will feed into the inflation backdrop. Consumer inflation expectations are still positive and suggestive of price growth around 2% which is good for inflation. We expect core inflation (the Bank of Japan’s target) to continue treading higher this year, towards 1%, but still below the Bank of Japan’s 2% target. This means that the BoJ will continue to run its stimulatory monetary policy settings for now.

Risks to the outlook

The planned consumption tax hike in 2019 is a key near-term risk to the economic upturn which could cause a fall in spending (as it did with the last tax hike in 2014 while only causing temporary inflation gains).

Another government risk is around the recent scandal involving Prime Minister Abe being allegedly linked in a land sale to a school operator which has resulted in a plunge in Abe’s poll ratings. This may limit any near-term ability to pass labourmarket reforms. There is also a leadership poll within the Liberal Democratic Party, but this is not until September, so Abe’s poll ratings may still improve by then.

The recent appreciation in the Japanese Yen may also provide a near-term headwind for businesses.

Longer-term structural risks for Japan are a declining population and the large stock of national public debt, but the majority of this debt is domestically owned which decreases financial stability risks.

stability risks. A medium-term upside risk to growth is the spending that will be linked to the Summer Olympics in 2020, driving government investment, which means that the current growth upturn may be prolonged for a few more years.

Implications for investors

Japanese growth and inflation has further room to increase in 2018 which is a positive environment for corporate earnings and Japanese equities. Japanese equities will benefit from the strong economic cycle, solid earnings growth, positive liquidity conditions from easy monetary policy. Japanese shares look particularly attractive especially relative to US shares which still look overvalued (despite the recent market correction).