Land of the Setting Sun?

From November until mid-May, it seemed Japanese Prime Minister Shinzo Abe had all the right moves. His “Three Arrows” strategy consisting of fiscal stimulus, monetary stimulus and structural economic reforms aiming to reinvigorate the long-lagging Japanese economy spurred a massive rally in Japanese stocks—in total, a gain of more than 70% (when priced in yen, more like 30% in US dollars) from the November 2012 trough through mid-May 2013. Yet in the last month or so, Shinzo’s shine has seemingly faded—in yen, the MSCI Japan has fallen about 19% from recent highs. (In US dollars, more than 10%.)

The media seems quick to want to label the move—is this downturn a Japan-specific bear market or merely a correction? But whatever you label recent movement, in our view, the future path for Japanese stocks doesn’t include materially outperforming the developed world. To see why, look what’s likely driven volatility: near-term sentiment on Abenomics. And in our view, the positive rally was a sign sentiment was outpacing reality—maybe by a longshot. That’s not a great recipe for sustained relative outperformance.

Why do we believe sentiment was outpacing reality? We believe the third arrow of Abenomics—the most important one, economic reform—will fall short, if launched at all.

Abenomics’ arrows one and two were launched right out of the gate. The government passed fiscal stimulus of roughly 2% of GDP. The Bank of Japan announced a new 2% CPI inflation target. Abe’s administration repeatedly offered assurance the third arrow would soon be unveiled. The previously strong yen, which many considered a headwind to the export-driven economy, weakened precipitously and stocks rallied further. To support its inflation target, new Bank of Japan governor Haruhiko Kuroda announced an unlimited bond buying program dubbed, “Qualitative and Quantitative Easing”—QQE. (We guess the extra “Q” is for added monetary oomph.) Part of the idea is to stave off deflation, another part is to spur selling of the yen in order to weaken the currency and make Japanese exports more price competitive. Stocks rallied more. Q1 GDP grew at a 3.5% Seasonally Adjusted Annual Rate initially—later revised up more, to 4.1%.

But all along, the third arrow hasn’t been unleashed. Japanese leaders have stated they’ll enter free trade talks, like those involving the mega-trade zone, the Trans-Pacific Partnership. But those talks rarely function well, and even if they do, it could take years to reach an implemented deal. Labor reform seems off the table. Mandating reforms for Japan’s outdated and uncompetitive Kereitsu are also absent. And there are many more examples.

What’s more, underneath the supposedly transformed economic data are many signs the Japanese economy just hasn’t been suddenly, fundamentally transformed. Underlying Q1’s headline GDP growth was falling business investment, a key variable in economic growth and innovation. Wednesday, core machinery orders posted a whopping -8.8% m/m decline in April. Now, admittedly, these data are volatile. But it’s not merely one data point. In fact, since Abenomics’ November launch, there have been three positive months and three negative—not a terribly dissimilar track record from the back-and-forth in the months preceding Abe’s arrival.

Thursday, Japanese Ministry of Finance data showed domestic investors were selling more foreign assets and buying domestic—not a factor that would support a weaker currency. While exports have increased (if measured in yen), removing the currency effect shows little positive influence from the weaker currency—a currency that’s strengthened in recent weeks.

Investors may for a time be willing to reward a seemingly determined leader. But fiscal stimulus and QE are easy moves, and arguably misguided ones. We remain quite skeptical of Japan’s ability to outperform moving forward.