Japanese Equities Still Merit Steep Underweight Ahead of December’s Election

Continued deterioration of the investment profile of Japan’s capital markets seems inevitable irrespective of the outcome of the national ballot next month and subsequent modifications of macroeconomic policies.  Already one of the world’s poorest performing equity markets in US dollar terms, the land of the rising sun also boasts equally worse sovereign debt market returns and a currency in precipitous decline – none of which conveys an auspicious impression of Japan as a reputable destination for foreign investment over any time horizon for the foreseeable future.

If ever a ballot appeared destined to render a verdict on a governing party’s economic record, Japan’s snap December parliamentary poll – in determining the political fate of Premier Shinzo Abe and his cabinet – is expected to disappoint the markets in that it is highly unlikely to engender a shift in the balance of power from the ruling Liberal-Democratic Party-Komeito coalition to its main rival, the Democratic Party of Japan (DJP), the next most popular electoral option.  Although the approval rating of Prime Minister Abe has plunged twenty-two percentage points from its April 2013 high of 66 to 44 percent currently, the Liberal Democrats (LDP) retain a sizable edge in voter surveys, the latest of which estimates a lead of 29.3 points in their favor.

Moreover, a severely splintered opposition poses little, or no, challenge to the LDP, which should make it virtually impossible for the former to mount a united campaign against the incumbent LDP-Komeito alliance.  Polling only 9.7 percent in support among eligible voters – according to a recent survey, the DJP stands nearly no chance of forming a ruling coalition, whereas the LDP will probably command sufficient popular support to assemble a government in coalition with the Komeito Party and press ahead with its unimpressive program for reflating the domestic economy that has proven largely ineffective in its bid to resuscitate sustainably the weak state of domestic demand.

A convergence of policymaking objectives, both fiscally and monetarily, may seem to be finally at hand thanks to Abe’s decision to postpone another planned, but politically unpopular, hike in the consumption tax next year and, if re-elected, enact another budgetary stimulus program coupled with a reduction in the corporate income tax.  However, with Japan’s national debt projected to surge to 264 percent of nominal GDP by 2030, the LDP-led regime faces a colossal dilemma, the enormity of which is reflected in the dismal performance of Japanese government bonds so far this year.  Yet another round of deficit spending by Tokyo to stimulate the economy would expand the fiscal shortfall, increase sovereign borrowing, augment the nation’s cumulative liabilities, running at 227 percent of money GDP presently, and imperil Japan’s image as a responsible debt manager.

As for monetary policy, signs of growing disunity have been surfacing for some time among Bank of Japan (BoJ) policymakers, many of whom have offered alternative measures for stoking inflation.  In spite of the fact that Governor Haruhiko Kuroda secured an enhanced majority among members (8-1) at the November 18-19 meetings of BoJ’s governing board in affirmation of the latest phase of quantitative credit relaxation, the unity among policymakers seems tentative and fragile.  Global Markets Intelligence (GMI) believes friction will likely re-emerge on the decision-making board when it becomes eminently apparent the latest draconian attempt to stimulate demand via financial channels fails to achieve its goal because of a persistent liquidity trap.

Meanwhile, the performance of the economy, having relapsed into a technical recession, is unlikely to recover any significant upside momentum until the second half of 2015.  Disinflation, possibly transitioning to deflation, remains a constant worry not just of BoJ policymakers, but investors as well – who remain unconvinced of the progress and efficacy of Abenomics, eponymous of the premier’s economic recuperation plan.  The persistent slump in domestic demand – despite an impending improvement in merchandise exports arising from the yen’s stable depreciation on both a bilateral and real effective, trade-weighted basis – should get little immediate relief from either household consumption or capital investment pending the onset of a steady speed-up in price pressures in the absence of stimuli from fiscal and monetary policies.

No persuasive fundamental rationale presently exists for either over-emphasizing or market-weighting Japan’s stock market any time in the foreseeable future.  Macroeconomic activity should remain feeble; dissension will likely resurface in the policymaking process; fiscal and credit policy impetus should fall short of breathing new life into domestic demand; the regime will forego its target of achieving a primary budget surplus before 2020; and the widely anticipated re-election of the LDP, in unison with the Komeito Party, will ensure four more years of ineffective Abenomics.  Despite our overall lack of conviction in the Japanese equity market, investors with a strong constitution for risk are advised to steer clear of energy and materials as well as consumer staples and cyclicals and concentrate instead on only those financial, industrial, health care and technology firms – the earnings of which could benefit greatly from additional government stimulus and, more importantly, a looming resurgence in overseas demand for domestically-manufactured merchandise.

Subscribe to Insights