Japan: Can the sun rise again?

We reveal our key macro findings from a recent fact-finding trip to Tokyo.

I recently spent ten days working from Tokyo, meeting Japanese companies and government representatives. As Japanese monetary divergence approaches a critical juncture, I present my key macro findings and how they might influence investor positioning as we head into 2023.

Inflation and BoJ policy

Given the global inflationary backdrop, there is a heightened level of debate as to whether inflation will properly take hold in Japan and whether this will cause the Bank of Japan (BoJ) to change its monetary policy – becoming the last central bank to abandon negative policy rates in the process. Headline inflation has been picking up in Japan, with the latest October print at 3.0% year on year. While core inflation (excluding fresh food and energy) has been picking up too, this remains below the BoJ’s 2.0% long-term objective, with the latest print at 1.8%.

After meeting numerous economists, representatives from the Ministry of Finance, and several Japanese corporations, and having observed the macro situation first hand, I believe that Japan will remain a global inflationary outlier, in common with the BoJ’s view, and do not believe that core inflation will become sustained above 2%. Consequently, we do not believe the BoJ will need to materially alter its monetary policy for a few reasons.

First, the Japanese consumer and small businesses remain generally cautious and fragile as Japan exits the Covid pandemic; demand is not about to explode. Secondly, the labour market is quite distinct in Japan. Despite low headline unemployment, there is a general fear and anxiety around job stability. Japanese companies avoided cutting headcount during the pandemic, and the consequence is a reluctance by workers to ask for wage increases as the economy recovers and labour mobility remains low in Japan for structural reasons.

Also, labour productivity, as measured by revenue per hour, remains stagnant. This is another reason why the labour market contains a degree of slack which makes wage increases difficult to justify at present. The third factor is a general lack of corporate pricing power over concerns that raising prices could mean losing market share. This is a natural response in an economy that has seen very little growth in recent decades and where excess capacities remain.

Fourth, the energy shock (and therefore headline inflation) has been a lot less pronounced in Japan than in Europe because, as I learned from my meetings with two of the largest Japanese liquid natural gas importers, contracts are long-term in nature and pricing dynamics are smoother. Japan has taken its energy security seriously for some years and was therefore relatively well positioned to meet the shocks of 2022. Fifth and finally, as the Japanese government demonstrated recently with its latest ¥30 trillion (US$200bn) additional fiscal measures, any headline inflationary pressures from energy, food and a weaker yen can be partially mitigated in the near term through government fiscal support.

BoJ Governor Haruhiko Kuroda’s term is up in April 2023 and his legacy is inextricably tied to that of former Prime Minister Shinzo Abe. Politically, is it highly unlikely that Kuroda will pivot away from the policies he has held on to for the last decade, and the most likely new governor candidates, Masayoshi Amamiya and Hiroshi Nakaso, are both likely to represent policy continuity.

Sovereign risk

Japan’s debt burden as gross debt to GDP sits at around 250%, so could there be potential for a sovereign crisis? This is a logical question given the eye-watering optics of Japan’s sovereign debt. I was initially sceptical about Japan’s debt sustainability, but following the trip my mindset has shifted.

There was no sense of urgency or impending panic from the government representatives I met. We believe interest rates are likely to remain at or close to zero, both for inflationary reasons discussed above, and because the size of the debt pile precludes higher rates, as the interest burden would itself be deflationary. I expect future nominal GDP growth to be modestly positive and for the government to aim for fiscal consolidation over time. For example, there are already measures in place to reduce the government cost of social entitlements.

In addition, the BoJ controls 50% of the combined Japanese government bond (JGB) and US Treasuries market (including through public pension funds) and has no plans for quantitative tightening. This significantly reduces the risk of a sharp sell-off in JGBs from bond vigilantes. Importantly, Japan’s banking system has large excess domestic savings (deposits are ¥350 trillion in excess of loan demand), so JGBs should continue to be domestically bid and foreign ownership is less than 15%, minimising the risk of destabilising outflows. 

Our view is that declining demographics, an ageing population, and a reluctance to accept sufficient immigration do contribute to longer-term debt sustainability risks, however, and these factors explain why the sovereign credit rating is A+ (S&P rating) rather than AAA. Nevertheless, practically, Japan cannot default in nominal terms on its debt because the BoJ can further increase purchases of JGBs or encourage domestic banks and insurance companies to make purchases.

Weaker yen and trade

The yen has been the weakest G10 currency in 2022 and the recent pace of decline led the Japanese government to intervene with two programmes in October, totalling $42.7bn. It is likely there will be further interventions if the pace of depreciation is too rapid, but attempting to defend a specific level is an impossible task given the enormous size of currency markets relative to government reserves. While yen depreciation provides a boost to exporters (competitiveness) and foreign subsidiaries (translated earnings), the weak yen is unpopular with consumers and has coincided with a sharp decline in Prime Minister Fumio Kishida’s popularity rating.

Given the generally weak level of Japanese competitiveness owing to lack of innovation and low productivity, my view is that the yen depreciation is welcomed by politicians more than they let on. It is a potential boost to economic growth (depending on the global macro picture next year), but also delays the inevitably required supply-side reforms that would be politically painful and could result in higher unemployment. Ultimately, Japan Inc. needs to reform and restructure, because productivity and innovation are poor, which also explains stagnant wage growth and weak consumption.

However, Japan’s external economy (as measured by the percentage of exports plus imports to GDP) is only 30%, which is low by G7 country standards. Furthermore, the trade balance has tipped into negative territory recently with higher energy-import prices and weaker tourism. The spillover effect of trade onto domestic GDP (the domestic trade multiplier) is only around 3%, according to one prominent economist I met (hence a 10% fall in trade would theoretically affect GDP by only 30 basis points). Therefore, Japan should, in theory, be quite insulated from a global recessionary perspective as its economic sensitivity to trade is far lower than that of regional rivals South Korea and Taiwan.

With other major economies likely to enter recession in 2023 owing to central-bank monetary tightening, and with rate differentials between Japan and other major economies likely to peak in the coming months, it is highly possible that the yen will regain its safe-haven status next year and subsequently undergo a moderate appreciation.

The relative appeal of the yen can also be found in Japan’s financial account which measures Japan’s stock of overseas loans and investments. Japan benefits from its status as the world’s largest creditor nation with a net overseas capital position of over ¥400 trillion (end 2021) and closer to ¥500 trillion today (c.US$3.5 trillion), which is almost equal in size to its economy (US$4.4 trillion in 2022 in nominal terms). This overseas capital stock typically generates current-account inflows of around 4% of GDP, and is a healthy offset to current trade-balance weakness, protecting the fundamentals of the yen.

Population and labour market

The forecast of the Organisation for Economic Co-operation and Development (OECD) that Japan’s labour force will shrink by 20% over the next 30 years highlights an urgent need to increase immigration. By one official estimate, Japan needs five million additional immigrant workers over this period,[1] with the rest of the labour-force decline met with increased automation, improved productivity, or a transition to lower labour-intensity sectors. There is very high resistance in Japan to allowing large-scale immigration, however. Low and middle-income workers oppose the competitive threat and downward pressure to wages that immigration would be likely to bring.

For society as a whole, which is 98% ethnic Japanese and socially conservative, the concerns around social instability from allowing immigration are a significant barrier. Language challenges and an inability to assimilate are viewed as a further challenge. The prospects for immigration offering much of a panacea to Japan’s population challenges therefore seem remote. Such challenges might be better addressed over the long term by enhancing youth labour prospects and improving child-raising affordability. However, such measures would come too late to arrest the labour-force decline projected by demographers.

Japan’s low unemployment rate, which currently stands at only 2.6%, masks many of the underlying challenges in the economy and labour market. Superficially, the labour market appears tight because Japanese companies cannot easily reduce headcount, and instead hang on to large workforces where productivity is low, and wages are consequently stagnant. The ‘job for life’ remains a prominent feature of the Japanese labour market. Unfortunately, when economic growth is close to zero, such dynamics create very weak incentives, which are compounded by age inequality in the workplace. Labour mobility and entrepreneurial start-ups are increasing, but a lack of social-security benefits often prevents effective risk-taking. Structural reform was the focus of one of former Prime Minister Abe’s ‘three arrows’, but a lot of work in this area remains to be done.

Politics

Japanese party politics, dominated by the Liberal Democratic Party (LDP), appears consensus-based to outsiders, but I learned from discussions with political experts that the party comprises some powerful factions with different leanings, and that they serve to block and check each other. At present, Prime Minister Kishida’s approval rating is low, and has been declining owing to rising inflation (real wage and cost of living challenge), the weaker yen, and the LDP’s proximity to the unpopular Church of Unification, which is viewed as a symbol of political corruption owing to its influence over certain politicians.

There are three years until the next Japanese election (2025), and several people I met expressed doubt that Kishida would remain in office for his full term, and that a younger, more dynamic candidate could replace him. A more market and reform-orientated candidate would undoubtedly be a positive for Japan’s economy and its equity market. In my view, however, the main challenge for Japanese politics is that ageing demographics mean that the older population cohort has appropriated the political system. This means that reforms in areas like labour relations and social-security entitlement will be slow. There is an effective transfer of wealth from the younger working population to the elderly retired population which is unhealthy for an economy. Without more dynamic leadership, the political status quo will persist, and reform will be very gradual.

Geopolitics

The US’s long-standing security guarantee means that the Japanese have been somewhat ‘geopolitically agnostic’ until now, but this is changing dramatically owing to unfolding world events. The China and North Korea threats are becoming more acute, and there is a creeping concern that perhaps the US security guarantee cannot be fully relied upon in the case of an emergency – particularly if Donald Trump or another US nationalist regains the White House in 2024. Japan must therefore be more proactive around its own self defence. There was little doubt from people I met that Japan’s defence spending to GDP ratio will double from 1% to 2%, but the pace and timing remain unclear. Prime Minister Kishida’s party faction is seen as being less hawkish on security than former Prime Minister Abe was, and so the near-term prospects for an official move away from the pacifist constitution by amending Article 9 are more remote under Kishida. While Japan’s self-defence forces are likely to continue to be given enhanced capabilities, it could take a real security event in northeast Asia for Japan’s political establishment to truly alter its foreign-policy stance.

Investment summary

While Japan’s economy is unlikely to emerge from its long period of low growth with a rip-roaring boom, the country’s underlying inflation dynamics, equally, are very well anchored. Hence, in our view, a change in BoJ policy that could catch markets off-guard is unlikely. While many economies are facing the disruptive impacts of inflation and central banks’ recession-inducing response, we think Japan can remain a bastion of relative stability. We therefore believe that there are attractions for global and multi-asset portfolios in an allocation to Japan throughout 2023.

While there is no escaping the long-term structural challenges that Japan faces in terms of its demographics and labour market, and its need ultimately to execute on reform, we believe the yen has been excessively oversold. The country’s real effective exchange rate relative to a basket of trading partners is at record lows, restoring a large margin of price competitiveness.

While the country’s exporters benefited from the yen’s depreciation this year, we believe that a partial recovery in the value of the yen in 2023, combined with the continuing benefits of post-pandemic economic reopening, means that investors should orientate towards more domestic-focused opportunities in the coming year. For longer-term investors, Japan’s ageing demographics and the need for greater levels of automation and robotics should remain key themes to seek exposure to.

[1] Nikkei Asia, February 3^rd 2022, Japan to require four times more foreign workers, study says

Authors

Richard Bullock

Portfolio manager, Fixed Income team