A Win for Abe and Japan: Challenges Lie Ahead

Author: Bill Witherell, Ph.D., Post Date: October 23, 2017

Prime Minister Shinzo Abe and his Liberal Democratic Party (LDP) achieved a landslide victory in the snap election held Sunday, assuring that his ruling coalition retains its two-thirds majority in Japan’s lower house. It also makes it very likely that Abe will be selected next year to continue to head the LDP. The LDP faced an opposition that was weak and divided. Abe’s popularity has recovered from damage done by several scandals earlier in the year, helped by his tough statements in reaction to threatening actions by North Korea and a strong economic record. Although the win may turn out to be bullish for Japan’s economy and stocks, the geopolitical implications may be even more important.

Abe has made clear his strong desire to amend Japan’s pacifist constitution, which contains restrictions on defense spending. His hand has been strengthened by this election, the increased threat from North Korea, and the signals from President Xi Jinping that China will follow a more assertive foreign policy. The uncertainty about US foreign policy under President Trump probably adds to Japan’s national security concerns. However, the Japanese public remains divided on the sensitive self-defense issue, and countries in the region are at best uneasy about the prospect of a militarily stronger Japan, which is understandable in view of history. It will take time for Abe to achieve any change in the constitution, which would first be subjected to a public referendum. But the pressure in that direction will be strong, with defense spending surely rising. A stronger Japan will change the geopolitical balance in the region, a development the United States should welcome. China and North Korea will view it adversely.

The prospect for Japan’s economic policy is a continuation of “Abenomics,” which has led the economy to expand for six straight quarters, with unemployment below 3%, the lowest rate in 23 years. This policy consists of three “arrows”: ultra-easy monetary policy under the leadership of Bank of Japan Governor Haruhiko Kuroda, fiscal stimulus, and structural reform. The first two arrows have been pursued aggressively, and this will continue. The Bank of Japan will continue to defend its yield target of “around 0% on ten-year government bond yields” and will avoid any indication of tightening its monetary policy stance. The government’s stimulative stance on fiscal policy is also unlikely to be changed, with increased defense spending helping to offset the effects of a scheduled sales tax increase next year.

On the other hand, Abe has procrastinated over pushing much-needed but unpopular structural reforms. The election results and the strong economy should lead the government to get moving on reform of the pension system, overhaul of the labor market, and increasing competition in Japan’s protected sectors, such as agriculture, retail, and other services. An important headwind for the Japanese economy is the ageing and declining population. So far, Abe has emphasized encouraging labor force participation of older workers. More difficult but needed are measures to improve female participation and promote immigration reform.

The most recent economic indicators suggest that the Japanese economy grew at a healthy 0.5% quarterly rate in the third quarter, only slightly slower than the second quarter’s 0.6% rate. Manufacturing growth rose to a four-month high in September, according to the Nikkei Japan Manufacturing PMI (purchasing managers’ index), published by Markit. Service sector activity slowed a bit, but Japanese service companies continued to increase their hiring. The latest Tankan Survey indicated that business sentiment had improved and that larger profits are leading to higher capital investment. Export growth is strong, with an acceleration of exports to China and exports to the US remaining firm. Economic growth for the current year looks likely to reach 1.7%, substantially stronger than the 1.0% gain in 2016. We are now projecting a similar 1.6% increase in 2018.

Japanese stocks have participated in the global bull market for equities, experiencing their longest winning streak since 1988. The largest Japan equity ETF on the US market, the iShares MSCI Japan ETF, EWJ, which covers about 85% of the investible universe of securities traded in Japan, has gained 18.48% year-to-date October 20 on a total return basis. This is a healthy advance, although less than the 27.38% gain of Eurozone equities as measured by the iShares MSCI Eurozone ETF, EZU. The main difference between these two returns to US dollar-based investors is that the euro gained over 11% during this period while the yen advanced only about 2.5%. As has been the case in a number of national markets, small-cap stocks have outperformed large caps in Japan. The WisdomTree Japan SmallCap Dividend Fund ETF, DFJ, has gained 23.42% year-to-date. It tracks an index of dividend-paying small-cap stocks. The election results lead us to maintain our positive view towards Japanese stocks .
Bill Witherell, Ph.D.
Chief Global Economist
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Sources: Oxford Economics, HIS Markit; The Financial Times, The Economist, Ned Davis Research, Bloomberg

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