Outlook 2019: Japanese equities

• Stable domestic policy environment could be offset by external risks
• Japan has continued to see a gradual improvement in domestic economic conditions
• Corporate profits responding positively to the improved domestic backdrop

Japan’s economy is gradually improving under a stable domestic policy environment, but external risks and trade friction could continue to affect investor sentiment in 2019.

Domestic policy environment to remain stable in 2019

After his reappointment as governor of the Bank of Japan in April, Governor Kuroda has continued to pursue an aggressive monetary policy stance with the aim of achieving a sustainable exit from deflation. However, since July, there has been considerable debate generated by Kuroda’s attempts to fine-tune the implementation of these policies without changing any of the headline objectives. Although this has been portrayed as a necessary transition to a more sustainable version of the same policy, these moves can also be interpreted as containing elements of tapering from the highly accommodative stance.

Following the Liberal Democratic Party’s (LDP) victory in a snap general election in October 2017 and his subsequent re-election as party leader in September 2018, Prime Minister Abe can now continue in his position, should he choose to do so, until 2021. In the process, he would become Japan’s longest serving prime minister.

Consumption tax to increase in October 2019

Shortly after the end of September, the government confirmed that the next increase in consumption tax would go ahead, as planned, in October 2019. The final decision on this had not been expected for several more months but the early announcement may simply be a reflection of the complexity of the implementation this time, rather than carrying any particular political message. In addition to a range of exemptions from the new higher rate, the government is also planning a series of stimulus measures designed to mitigate the extent of economic dislocation seen around previous tax increases. At this stage, it is unclear what the net impact to the economy of all these measures might be.

Meanwhile, although we expect no substantive change to monetary policy in the near future, there is a chance that the Bank of Japan may choose to act earlier than strictly necessary in order to avoid making any change around the same time as the tax increase.

Beyond October 2019, long-term equity investors should be considering the possibility of an exit from current monetary policies within their time-horizon. If the authorities are able to declare a sustainable exit from deflation, this could dovetail well with the final stages of Prime Minister Abe’s tenure. Although these appear to be largely political considerations, they reflect the underlying improvements in the real economy which are, in turn, driving the corporate profit growth we are expecting over the next couple of years.

Gradual improvement in domestic economy

Japan has continued to see a gradual improvement in domestic economic conditions despite some short-term weakness in headline GDP in the first quarter of 2018.

Meanwhile, the labour market has continued to show sustained improvement, which is maintaining upward pressure on wages. The extent to which higher participation rates have offset Japan’s known demographic issues continues to be widely under-reported, but should properly be regarded as a key success for government policy. Although this particular trend must reach a natural peak soon, the tightness of the labour market is capable of sustaining the recent upward pressure on wages. This will ultimately feed through to inflationary expectations which will, in turn, generate better pricing power for domestic-oriented companies.

Capital expenditure is also running well ahead of companies’ earlier expectations. This is partly a rational response to the macro impact of labour shortages but is also a reversal of the long-term trend of underinvestment, especially in technology and systems, through the period of deflation.

Japan has avoided confrontation with the US, for now…

Against this domestic stability, considerable uncertainty has been generated by the rapid escalation of trade issues between the US and China. Japan has avoided a focus on its own trade surplus with the US but the persistent imbalance in autos, in particular, remains a potential easy target for the Trump administration. The secondary effects of the US dispute with China could also become more significant for Japan over the next twelve months.

Foreign investors remain unconvinced

Overseas investors have continued to take a relatively fickle approach to Japanese equities. In aggregate foreigners tend to be influenced by market momentum, appearing as sellers into market weakness and buyers into strength. The result is that we have seen no follow-through from the improved visibility on corporate profits and the recent market setback has led to further de-rating of market valuations.

Meanwhile, the Bank of Japan remains a large consistent buyer of equities via ETFs. Although this may be an effective route for its asset purchase programme, it also carries an increasing risk of distorting market prices. For 2019, however, there is no reason to expect the scale of buying to fade, and it is definitely much too early to worry about the potential impact of the central banks holdings being unwound.

Corporate profits responding to economic improvements

While a modest pick-up in inflation and wages will imply some higher costs, corporate profits are generally responding positively to the improving domestic conditions as companies begin to regain some pricing power after almost two decades of deflation.

While investors seem destined to live with higher levels of external risks, especially on trade, some of the domestic risks have receded in recent quarters and we should therefore have more conviction in our view of current Japanese equity market valuations.