Political uncertainty on the horizon
Japan stands at the crossroads as the country undergoes a wave of leadership transitions. Following former Prime Minister Fumio Kishida’s resignation, newly appointed Prime Minister Shigeru Ishiba swiftly announced a new Cabinet and moved to dissolve the Lower House, so as to pave the way for fresh elections on 27 Oct 2024.
Prior to the elections, media reports cited the possibility that the ruling coalition of the Liberal Democratic Party (LDP) and its partner Komei Party could fare poorly but the eventual result was likely worse than expected. The LDP registered a significant loss of seats, from 247 to 191 while the Komei Party saw its seat count dropping from 32 to 24. This resulted in the ruling coalition falling short of the 233 seats needed to command a majority in the Lower House.
At this stage, it remains difficult to be certain on how the final complexion of government will look like. In our view, the 3 plausible scenarios from here are:
Notwithstanding the above, a new administrative structure needs to be decided in November, given that a Special Diet session needs to be called within 30 days of the general election so as to appoint a Prime Minister.
Expecting broadly unchanged fiscal and monetary policy direction for now
Despite the political uncertainty, fiscal policy is likely to remain broadly unchanged for now, though we do not rule out areas where policy could become marginally more expansionary. This is because (i) smaller opposition parties like the DPFP and the JIP are advocating for consumption and gasoline tax cuts, while (ii) the heavy defeat by the LDP in the Lower House elections should give the Upper House elections in 2025 renewed significance. Markets are likely pricing in some of this as well, with the Nikkei 225 Index and 10Y Japanese Government Bond (JGB) yield trending higher following the results of the election.
As for monetary policy, we believe the outlook here remains unchanged, as core inflation appears to be settling around the 2% handle, and there are reasons to remain optimistic that Japan will be able to stay on the path of sustainable reflation, breaking the three decade deflationary cycle.
First, while firms had broadly refrained from passing on higher costs to consumers earlier this year, an increasing number of firms are now looking to do so as domestic demand recovers.
Second, wages look to be on a continued uptrend. It has been reported that Japan’s trade union confederation (Rengo) will be targeting wage hikes of “5% or more” in its 2025 spring wage negotiations, while pushing for a more aggressive target of “6% or more” for small and medium-sized enterprises. This would help to build on the strength of strong wage growth registered since 2023. This should also help to spur broad consumption and further feed into overall prices, thus creating a virtuous cycle across inflation and wages.
Hence, we see the BoJ continuing to raise rates as it embarks on gradual normalisation in light of the underlying inflationary trend. Across the various parties, we see little political pushback on higher rates due to the need to keep inflation in check, which is in-line with our view that the recent weakness of the JPY is likely to be temporal, especially as other central banks pursue rate cuts.
Flows into Japan also dependent on outlook of China
The policy stimulus blitz in China is likely to have a mixed impact on risk assets in Japan. As we expect further policy stimulus to help support China’s economy and ultimately spur consumption, this should also provide a mild boost to Japan’s economy. This is because China constitutes ~20% of trading value for Japan in FY2023 (as a proportion of the top 5 markets for Japan), and is thus Japan’s largest trading partner.
Exhibit 1: China is Japan’s largest trading partner
Source: Ministry of Finance, Bank of Singapore
However, given undemanding valuations in China, investors with a sizeable Asian allocation who prefer exposure to China might prefer to fund that from their existing Japanese holdings.
We are Neutral on Japan equities as the risk-reward appears balanced at this juncture. However, taking into account the macro and rates outlook, we see specific sectoral opportunities, including:
(a) Japanese banks as gradual interest rate normalisation will help boost return on equity (ROE) levels over time,
(b) Domestic-oriented sectors given our expectation of rising real wages and JPY appreciation ahead, and
(c) Industrial automation and robotics, benefiting from the bottoming in China’s economic growth coupled with the global easing in interest rates ahead.
Across Japan fixed income, we prefer:
(a) Selected subdebts issued by Japanese Life Insurers as a number of them appear attractively priced vs Banks’ senior Total Loss-Absorbing Capacity (TLACs), and
(b) Selected corporate borrowers, such as those with improved liquidity positions, better operational performance and significant domestic revenue levels.
Japan’s economy reflates, interest rates to rise
Despite Japan’s long-ruling LDP losing its majority in October’s election, the economy remains likely to finally escape deflation but at the cost of interest rates rising further over the next year.
Indeed, Japan’s economy is at last moving on from its three lost decades of weak inflation and outright deflation that caused growth to stagnate after its 1980s bubble burst. Exhibit 2 shows the size of the economy exceeded JPY600t (USD4t) for the first time this year, helping spur the Nikkei 225 Index to surpass its previous peak of 39,000 set in 1989 and make new record highs above 40,000.
Exhibit 2: Nominal GDP
Source: Bloomberg, Bank of Singapore
Japan’s economy is reflating again as the shocks of the pandemic, the wars in the Ukraine and the Middle East, still very low interest rates and the weakness of the JPY have caused inflation to return to the BoJ’s 2% target.
Exhibit 3: Core Inflation
Source: Bloomberg, Bank of Singapore
Exhibit 3 shows core inflation, excluding fresh food and energy costs, is setting around 2% after jumping to four decade-highs above 4% when Japan fully reopened from the pandemic.
In contrast to previous bursts of inflation caused by sales tax rises in 1997 and 2014, this decade’s surge is set to be sustained as tight labour markets after the pandemic have led to the strongest increases in wages for three decades. Thus, the prices of labour-dependent services are rising close to 2% for the first time since the early 1990s as Exhibit 4 shows.
Exhibit 4: Core Inflation
Source: Bloomberg, Bank of Singapore
Services inflation is more durable than changes in goods prices, raising hopes the BoJ will be able to keep meeting its 2% inflation goal now. But while Japan’s reflating economy has spurred the Nikkei 225 Index, the BoJ has also been forced to raise interest rates twice this year from -0.10% to 0.25% now.
Exhibit 5: Bank of Japan Interest Rates
Source: Bloomberg, Bank of Singapore
We think the BoJ will need to raise interest rates to 0.50% by the end of this year and 1.00% next year to keep inflation at its 2% target. Thus, investors will need to balance the promising end to Japan’s lost decades with higher interest rates now.
JPY – Gradual appreciation
The environment has turned less JPY-friendly following the JPY’s strong summer rally driven by carry trade unwind. USDJPY has recently rebounded on widening US-Japan yield differentials. But the setback for the JPY is unlikely to last. A USDJPY rally beyond 150 would raise BoJ’s hiking prospects, thereby putting a cap on USDJPY.
We continue to think that the JPY can modestly appreciate, targeting USDJPY at 137 in a year’s time. JPY valuations are still exceptionally cheap, and the currency should be supported by the BoJ hikes while other central banks pursue rate cuts. Among the low-yielders, we still prefer CHF to JPY as the funder of choice.
Exhibit 6: USDJPY and US-Japan yield differential
Source: Bloomberg, Bank of Singapore.
JPY performs best when both US yields and equities are falling. Such an outcome could happen if there is a hard landing in the US economy, requiring more aggressive rate cuts by the Federal Reserve (Fed). But more upbeat US dataflow pointing to lower recession risk has not only driven 10Y US Treasury (UST) yields back above 4% but also kept US equities supported even as investors are cautious over stretched valuations.
But following a significant repricing of terminal rates – the level at which the Fed stops cutting – from sub-3% in September back to the vicinity of our estimate of US neutral rate at 3.0-3.5% (the rate that neither stimulates nor slows down US economic activity being about 2%), the scope for additional USDJPY gains is likely to be more limited.
Japan’s election results show that the LDP-Komei Party coalition has fallen short of securing the 233 seats needed for an overall majority in the lower house. The parties have 30 days to agree on the composition of the new government. Political uncertainty has also weighed on the JPY. But renewed weakening of the JPY is likely to increase pressure on BoJ to hike rates, which in turn should help limit further USDJPY upside. The authorities could also counter JPY weakness with FX intervention warnings.
Exhibit 7: Wage growth has finally risen in Japan
Note: Same sample basis
Source: Bloomberg, Bank of Singapore
We expect the pace and extent of the BoJ hikes to exceed the current interest rate pricing, paving the way for a stronger JPY. The BoJ has maintained that it would adjust the extent to which monetary policy is accommodative by hiking rates if the virtuous cycle between wages and prices develops in line with the central bank’s outlook.
Solid wage gains provide more proof the BoJ’s outlook is on track. A nearly 3% year-on-year (YoY) rise in scheduled earnings in August is the fastest pace of gains since the early 1990s.
A shift by Japanese investors away from their long-held “invest overseas” strategy is an area we are watching closely. We are not seeing such a behaviour shift although the Government Pension Investment Fund is due to review its medium-term investment plans soon. A change of tack to boost its allocation to domestic assets in the upcoming review could add to JPY strength.
Equities – Risk-reward appears balanced at this juncture
We foresee continued volatility for Japanese equities in the near term following the unexpected outcome of the Lower House elections on 27 October 2024, which could lead to uncertainties over policy direction and implementation. The upcoming US elections in early November would also act as a source of uncertainty. Furthermore, fluctuations in the JPY are expected to contribute to market volatility. We note that the correlation (rolling 12-month basis) between the performance of the MSCI Japan Index and USDJPY rate has risen more sharply since July this year. Positive earnings revision momentum by the street has also waned over the past few weeks. Looking at investor flows data from Japan Exchange Group, there was a marked shift in sentiment from foreign investors towards Japanese equities, as they net sold JPY2.9t of equities on the Tokyo Stock Exchange Prime Market for the month of September. This was a reversal as compared to five consecutive months of net inflows from April to August 2024. However, we note that inflows from foreign investors turned positive again for the three weeks ending 18 Oct (JPY639b).
Other positives include ongoing corporate governance reforms, higher Nippon Individual Savings Account (NISA) participation rates and transition to an inflationary economy which are medium to longer-term drivers for the Japanese equity market.
In terms of positioning, we see opportunities in Japanese banks following their share price pullbacks from the peak, coupled with our house view that the BoJ will hike its benchmark rate by another 25bps in December to 0.50%. The gradual normalisation in interest rates will support the improvements in Japanese banks’ ROE over time.
We also like domestic-oriented sectors and companies given our expectations of JPY appreciation ahead. Rising real wages can provide a boost to domestic consumption. Besides Japanese banks and domestic-oriented companies, there are also opportunities within the industrial automation and generative artificial intelligence (AI) space.
Japan’s factory automation players could see tailwinds from the bottoming of China’s economic growth and global interest rate cuts. Japan robot orders, a leading indicator of factory activity, surpassed robot shipments in 2Q24 for the first time since 4Q22, and this could suggest the start of a recovery.
Fixed Income – Premium for scarcity
Japanese credits have continued to garner strong demand and we attribute it to the lack of supply and the issuers are considered as having strong fundamentals with high overall ratings (averaging “A”-ratings). Issuances by Japan are dominated by financials (both banks and insurance companies) with corporates mostly well-placed in Investment Grade (IG) ratings and a handful of names in the High Yield (HY) ratings.
Fluctuations in the JPY are expected to contribute to volatility in the credit market; as seen in the early August market sell-off which was triggered by the unwinding of the JPY carry trades, following strong JPY appreciation and a hawkish BoJ.
For Japan corporate borrowers, the biggest impact from JPY appreciation is a reduction on the translated income from non-JPY proceeds. All else equal, this will result in earnings drag but we think this factor alone is unlikely to trigger concerns among investors and rating agencies.
For Japan financials (banks and life insurance companies), the implications from the market volatility appear manageable:
JPY appreciation: Strong JPY reduces earnings due to lower translation gains given substantial exposure to non-JPY assets. For banks, the loan repricing from BoJ rate hike more than offset the earnings drag from JPY movements. For insurers, the overall higher hedging costs have resulted in a recalibration on their investment approach, including a reduction in hedged foreign exposure.
BoJ rate hike: For banks, BoJ rate hike allows margin expansion (with loan repricing more impact than deposit repricing). Mark-to-market (MTM) losses on bonds are likely to be modest given the gradual rise in yields but higher net interest margin will boost banks’ profitability. For insurers, there has been a notable increase in insurer’s investments into JGBs, which we think is credit positive as that is accompanied with a boost to its liquidity and solvency profile.
Equity market sell-off: Unrealised gains from equity portfolio will likely fall but it is unlikely to have a material impact on banks’ CET1 ratios. For insurers, equity exposure has increased over the past two years, but this is largely due to market appreciation, instead of new positions. Despite this trend, the underlying strategy of most insurers has been to trim equity exposure to mitigate market risk and promote portfolio stability.
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