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Market Commentary

Will Japan Lead Asia’s Markets in 2013?
December 27, 2012  Bill Witherell, Cumberland’s Chief Global Economist

In my recent commentary on Asia-Pacific’s equity markets, I hesitated to include Japan in my positive outlook for the region.  Japan had disappointed so many times in the past when there were reasons to hope for a recovery from several decades of depressed markets and deflation.  However, we now have become believers that Japan, under the new government led by Prime Minister Abe, is “for real.” We have added overweight positions in Japan to our “Asia-Pacific Tilt” for our International and Global Multi-Asset Class portfolios. The reasons for this strategy change are discussed below.

Shinzo Abe, leader of the Liberal Democratic Party (LDP), campaigned on a promise of fast, aggressive action – a combination of vigorous monetary easing and substantial fiscal stimulus – to end Japan’s prolonged economic slump.  Abe won a landslide victory in this month’s general election, securing a critical two-thirds majority in the lower house and a clear mandate to implement policies aimed at combating deflation.  He was officially chosen by Japan’s parliament as prime minister yesterday, December 26.  He moved quickly to form a cabinet of proponents of fiscal stimulus, including former prime minister Taro Aso, who was tapped to be the new finance minister.  The contrast with the outgoing government’s emphasis on fiscal consolidation is clear.

A dramatic change in monetary policy also appears to be assured, despite the supposed “independence” of Japan’s central bank, the Bank of Japan (BOJ). Abe is convinced the persistent strength of the yen and deflation are the primary causes of Japan’s lengthy period of economic underperformance. He charges the BOJ, with some justice in our view, with having been too timid in its current asset buying program, Japan’s version of quantitative easing, and in its excessive concern about inflation. He calls for aggressive monetary easing and an increase in the BOJ’s consumer price inflation “goal” to 2% from the current 1%.

We do not agree, however, with Abe’s threat to revise the legislation protecting the independence of the BOJ if the latter does not change its policies in the direction he requests. While the BOJ’s independence from political consideration has never been 100%, it would be a shame for the central bank to lose the freedom of action it now has.  The relevant law provides that the autonomy of the BOJ in setting monetary policy is to be respected. It also indicates, however, that the BOJ should ensure that its actions are compatible with the government’s economic policy.

We expect the BOJ will decide to adopt a significantly more aggressive policy of monetary easing  – printing money – while maintaining interest rates close to zero.  The BOJ has announced that it will review the current inflation goal in January, and most likely will accept Abe’s goal of 2%. The market, anticipating these policy moves, has already driven the yen down to levels not seen in recent years – 85.94 yen/US$ as of December 27th.  This rate is the lowest level against the US dollar in more than two years. (Note that the exchange rate between the yen and the US$ is usually expressed as yen per US$, so a depreciating yen will result in this figure becoming larger.)  We would not be surprised to see this rate move above 100 yen to the US$ in 2013. Sustained yen weakness will be strongly positive for export-oriented Japanese companies and their stocks.

Abe’s call for “flexible fiscal policy and a growth strategy that encourages private investment” also promises to add an important stimulus to the economy and the markets.  The fact that Japan has recently entered its fifth recession in 15 years means that a stimulus program is certainly warranted.  Abe’s strong majority in the lower house should assure the enactment of such a program.  We are, however, concerned about the medium-term implications for Japan’s fiscal situation, with gross public debt already in excess of 200% of GDP.

The implications for Japanese equities in 2013, however, should be distinctly positive. It now seems much more likely that corporate profits will experience a V-shaped recovery.  As domestic investors come to have confidence that the yen weakness will continue and profits recover, their demand for Japanese equities could surge, following the significant increase in foreign investor interest in Japanese equities already underway. The Japanese equity market, as measured by the MSCI index for Japan in US dollar terms, has already begun to outperform, up 4.51% so far this month, as compared with an increase of only 1.56% over the same period for the MSCI World Index. We expect that Japan’s outperformance will continue in the coming months, playing a leading role in the anticipated strong growth in the Asia-Pacific region.

Bill Witherell, Cumberland’s Chief Global Economist

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