Shinzo’s Stalemate

One year ago, Japanese Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP) cruised to victory on promises to revive Japan's economy with a three-pronged—nay, "three arrow"—program. Dubbed "Abenomics," the program entailed aggressive monetary stimulus (arrow 1), fiscal stimulus (arrow 2) and economic reform (arrow 3). Abe unleashed arrows 1 and 2 in short order, and Japan bounced out of recession—with arrow 3 seemingly notched, investors everywhere seemed sure Japan would finally bust out of its 15-year malaise. Yet here we are today, with nary a reform in sight and Japanese growth slowing ... and investors still expecting the moon. While there is certainly time for Abe and the LDP to push through reforms, the changes Japan needs will require Abe to take on powerful vested interests. As a recent dust-up over sales tax hikes shows, this is easier said than done, and the likelihood reform comes close to investors' expectations seems slim—something investors buying into the Japanese reawakening story should consider.

The sales tax, funnily enough, is largely why Abe is in office. His predecessor, the Democratic Party of Japan's Yoshihiko Noda, pushed the tax through Parliament last year, but it was his downfall—his popularity plunged, and the LDP forced his hand. But though Noda fell, the tax hike survived, and Abe inherited it. For a while, some speculated he’d shelve it in the name of economic stimulus, but when Japan's gross public debt passed ¥1 quadrillion (over 220% of GDP) earlier this year, officials decided raising revenue to tackle the debt trumped other concerns. Two months ago, Abe announced he wouldn't seek a repeal.

Sticking with that decision, in our view, would have shown Abe had the chutzpah necessary to push through politically difficult changes. Yet like all politicians, Abe proved to be, well, a politician. The tax hike stands, but so do measures to shore up support as it takes effect. Like adopting a ¥5.5 trillion stimulus package to offset any potential pinch. We'll not belabor the oddities of offsetting a deficit-reduction measure with higher spending. But it suggests political pressures over even simple changes have pushed Abe into bizarre decisions to try to satisfy everyone. This doesn’t exactly inspire confidence in more difficult reform efforts.

To coalition partner New Komeito, it seems the stimulus pledge doesn't go far enough. To fulfill a campaign pledge, New Komeito wants necessities (like food) to be taxed at a lower rate than non-essentials. But the LDP believes this would reduce revenue by 20%, undermining deficit reduction goals.

Interestingly, while New Komeito's proposal might help LDP curry favor, Abe and the Finance Ministry are resisting—Thursday’s implementation proposal said nothing about lower rates for "essential" items. But the debate persists, and cracks in the coalition are showing. Which raises a question: If Abe doesn't have enough political clout to keep an otherwise economically aligned coalition from splintering over a tax hike passed by a previous government over a year ago, how will he pull off deep structural changes?

Structural economic reform isn’t easy anywhere—if it were, it’d be a non-issue. In Japan especially, it requires taking on powerful interests—interests and lobbies that are largely responsible for LDP’s electoral domination. Improving small firms’ ability to compete with mega-conglomerates will irk keidanren, Japan’s business federation. Modernizing the energy grid and reforming energy markets will roil the powerful regional energy monopolies. Restarting nuclear plants will vex voters. Dropping corporate taxes will peeve all the consumers about to get dinged by higher sales tax. Ending lifetime employment and other antiquated labor restrictions will whack workers. Privatizing Japan Post will upset savers who enjoy the artificially high deposit rates it offers. All are vital to restoring Japan’s competitiveness, but all introduce political risk—poison to a pol in people-pleasing mode—and will be manifestly more difficult than battling a coalition partner over how to implement an already-passed sales tax hike.

Agriculture is another difficult undertaking. Japan is infamous for excessive tariffs, import restrictions and subsidies to protect farmers. Not only does this limit production and keep prices artificially high, it also creates barriers to overall trade. Ending these policies would allow Japan to sign many more trade pacts, but the electoral system heavily favors voters in rural areas (farmers), where much of Abe’s support is based. LDP enjoyed a 30-year reign in the 󈦜s-󈦺s as a result, and rural votes won Abe the last election. Common wisdom says upsetting farmers could put Abe on the other side of Japan’s revolving door. Yet, here, Abe is pushing forward a bit. He recently proposed legislation to (very) slowly unwind some for rice farmers and consolidate smaller farms. But proposals aren’t bills, never mind laws—the administration could yet bow to pressure from the agricultural lobby, which is already screaming.

Even if it passes, many more reforms—packing bigger punches—remain on the sidelines. Abe has announced plans to tackle some of these issues, like targeted tax breaks to enable conglomerate reform, which will no doubt help. But deeper issues like antiquated labor markets appear off the table for now. And the longer the coalition stays split over sales taxes, the deeper the rift grows, the more distracted they become, and the less likely deep reform appears. As long as structural change remains a pipe dream, it's tough to imagine Japanese growth matching investors' lofty expectations.

Japanese stocks likely follow the same trend. Stocks move most on the gap between reality and expectations. High expectations and disappointing reality are a recipe for disappointing stock returns. Japanese stocks’ sharp outperformance at the beginning of 2013 has cooled markedly since May, given the fundamental and sentiment backdrop. Yet big bulls remain. Considering how far away meaningful reform likely is, better investing opportunities likely lie elsewhere.