We’re (Not) All Turning Japanese

Japanese stocks fell about 7% on Thursday, in part based on a negative Chinese manufacturing report. No matter how big a move up or down, a single day’s move says nothing about future direction. However, in our view there are likely better opportunities elsewhere in 2013.

Prior to Thursday, Japanese stocks were enjoying something of a rally—in our view tied to more shorter-term and likely fleeting sentiment factors than anything more fundamental. Markets seemingly have liked Prime Minister Shinzo Abe’s “three arrow” plan to revive the country’s long stagnating economy. (Abe’s campaign kicked off November 15, 2012, just as stocks started rallying, and his party won on December 16.) As we detailed recently, Abe quickly unleashed arrows one and two: Fiscal stimulus in the form of ¥13.1 trillion in government investment and quantitative easing in the form of the Bank of Japan’s (BoJ) 2% inflation-targeting program. And Q1 Japanese GDP reportedly rose a robust +3.5% y/y—seemingly validating progress.

The third arrow is structural economic reform, which Japan badly needs. It has long suffered under stagnation and bouts of deflation tied to long-running declines in productivity, a shrinking workforce, high trade barriers and a lack of dynamism in the corporate sector. Yet, in our view, it’s likely that third arrow stays in Abe’s quiver for some time. Structural economic reform in Japan requires tremendous political capital and has been the undoing of many of Japan’s governments in the recent past—leading to eight Prime Ministers in as many years (including Abe once before) and exacerbating the economic malaise.Abe has promised to release plans for structural economic reforms before the G-7 Summit in June. However, too many questions remain unanswered to know if it’ll be enough to turn Japan’s economy around and how fast: How deep will his proposed reforms go? What will parliament actually pass? How will the electorate react to proposed reforms?

Plus, we’ve seen this story play out before—fiscal stimulus efforts under previous governments produced a short-term boost, but underlying structural economic weaknesses eventually pulled markets and growth back to reality. As a result, Japan has experienced 5 recessions in the last 15 years alone. In that time, business investment—the key economic engine of any advanced economy—has steadily declined. Likewise, 12 years of on-and-off QE efforts have yielded few results. Much like their US and UK counterparts, Japanese banks have opted to park much of the money unleashed by QE efforts right back at the BoJ as excess reserves, instead of allowing them to flow through the broader economy via bank lending.

Of course, some policymakers cheer QE’s weakening of the yen, arguing it aids Japanese exporters. In our view, this is a dubious claim. A weaker yen makes imports into Japan more expensive—an acute problem as the country relies on foreign energy imports and imported intermediate goods for manufacturing—raising manufacturing costs in the country.

Another impact of the weakening yen many folks miss—only domestic investors have enjoyed most of the Japanese equity market’s recent gains. Investors in non-yen currencies haven’t captured anywhere near as much, as a weakening yen has severely dampened returns denominated in stronger foreign currencies—the dollar included. This currency headwind, along with doubts over Abe’s yet unleashed third arrow of fixes for Japan’s deep structural economic issues, make us skeptical Japan’s stock rally has firm footing.