Today we have a guest post by Venk Lal, director of global equity, investment risk management, for the EverKey Global Equity team at Wells Capital Management. Venk discusses the recent volatility in Japan and the likely next round of reforms from the Abe government.
“Courageous and decisive decision-making and execution is the only option for overcoming our difficulties.” Shinzo Abe, Prime Minister of Japan, June 19, 2013, London
A volatile several weeks in Japan’s capital markets have given pause to some international investors. Since the Bank of Japan (BOJ) announced its quantitative and qualitative monetary easing policies on April 4, the Nikkei equity index first rose and then fell 25% peak-to-trough, while the yen experienced a 10% reversal, essentially round-tripping over the course of April through mid-June. With the Nikkei now still 50% stronger and the yen 20% weaker from levels since Prime Minister Abe’s electoral victory last December, investors are wondering if the Nikkei’s remarkable run represents a flash in the pan—perhaps fueled by a speculative rush of capital—or the beginning of a more substantive change: from a coordinated expansion of fiscal and monetary policies, to much-needed structural reforms that promote growth, to the end goal of self-sustaining capital flows.
Abe-nomics appears to be in the early stages of implementation, but it also represents a major overhaul of Japan’s economic policy requiring diligent domestic and international policy coordination. Followers of Japanese markets are accustomed to unsatisfactory political gridlock and policy incrementalism, so market volatility in the face of big promises seems a natural and skeptical response, of which the markets have exhibited several classic hallmarks: profit-taking from an overextended short-term rally; levered carry trades normalizing, especially in a period of rising U.S. interest rates and sensitivity over the U.S. Federal Reserve’s potential tapering of quantitative easing; and investor expectations resetting as neither Abe nor BOJ Governor Kuroda showed signs of responding to moment-to-moment market consternation with reactive (or potentially credibility-diluting) policy pronouncements in recent weeks.
The careful and deliberate sequencing of Abe-nomics has likely only just begun
Investors shouldn’t expect Abe’s government to make reactionary announcements to market volatility, as careful and deliberate sequencing of public policy advances remains at the heart of Abe’s steady reflationary agenda. The BOJ has only in recent days begun its enhanced open market Japanese government bond and equity purchases, and Abe may likely be awaiting the results of the July 21 Upper House parliamentary elections (and the associated possible further consolidation of political legitimacy) before unveiling detailed steps in structural reform to further extend the reflationary mandate of his administration.
Abe’s pro-growth structural reforms aim to provide a multipronged strategy to propel reflation, targeting 3%-plus in nominal gross domestic product (GDP) growth, with sensitivity to keeping nominal growth comfortably above nominal interest rates. By those measures, the Abe government’s fiscal and monetary policies already seem to be on a constructive track. GDP growth jumped from negative annualized 3.6% in the fourth quarter of 2012 to 4.1% in the first quarter of 2013; export growth surged in May by the most since 2010; consumer and business sentiment are reviving; bank lending is rising; and major urban real estate is recuperating.
The next round of reforms
We believe that equity investors will welcome the depth and breadth of structural reforms once they are likely announced later this summer and fall. Given Abe’s recent public statements, the next round of reforms will likely be aimed at reinvigorating corporate productivity:
- Reforming tax legislation (for example, research and development and capital expenditure incentives, credits for wage hikes, retail individual savings account promotions)
- Promoting private finance (such as private management of government-controlled airports and infrastructure privatizations, tripling private investment to $1.2 trillion within seven years)
- Encouraging foreign investment and trade (national strategic special zones set up enticing foreign private enterprise, doubling by $370 billion in seven years, completing Trans-Pacific Partnership [TPP] free-trade area negotiations, relaxing tourism)
- Enhancing corporate governance (promoting outside board directors, adopting a U.K.-style Stewardship Code, reviewing strategic asset allocations, including the Government Pension Investment Fund [GPIF])
- Reforming the labor market (boosting female workforce participation, subsidizing child care, enhancing mobility-retooling investments, and potentially allowing more foreign skilled workers)
Targeted industrial programs will affect energy (deregulating electricity, ending oligopolies by splitting generation from transmission, restarting nuclear, developing alternatives), agriculture (rationalizing industry dynamics), health care (accelerating drug pipelines, promoting equipment exports and next-stage regenerative information technology incentives), and other sectors.
Unlocking pent-up assets and wealth
Abe’s political program appears to be designed to stimulate domestic animal spirits, potentially unlocking a portion of more than $15 trillion in household and government assets and wealth that hold a key to overcoming Japan’s long-term deleveraging and demographic dilemmas. Japan’s massive GPIF is allocated to Japanese stocks at levels well below what it held in 2005, while Japanese households allocate, on average, only about 10% of their portfolios to equities, about one half of what their European and one fourth of what their American counterparts hold. By our conservative estimates, if GPIF raised its Japanese equities allocation to 2005 levels and if Japanese households were successfully encouraged to allocate more to equities, these moves would translate into nearly 50% of Japan’s stock market’s capitalization, in terms of incremental equity market demand.
In addition, the Abe government’s new focus on domestic efficiencies and international trade offers exciting prospects for generating attractive investment returns over the next several quarters. While we remain watchful of ongoing developments, we believe that the recent sell-off provides patient, fundamental investors with compelling opportunities to revisit and resize selected positions.