J-Money: What European Investors Make of Abenomics

J-Money, July 2016

European investors and bankers have been watching the progress of Abenomics and Japanese quantitative easing with interest. The jury is still out on whether it will work – particularly since the volatility of late May and June – but most are positive about the intent.

“I think the broad thrust of what Shinzo Abe is doing is extremely commendable,” says Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh. “Although there have been a few faltering steps in recent weeks, you have to say he has hit the ground running.”

In particular, analysts are supportive of the scale of Japan’s programme, especially the quantitative easing by the Bank of Japan. “If you’re going to try something to deal with Japan’s problems, you need to do it on a hefty scale, and that is what they have done,” says Christopher Beauchamp, market analyst at IG Markets in London.  “They have thrown the book at this, in terms of quantitative easing. The sheer scale of the policy, not just on the monetary side but fiscal, with government coming into office with a clear pledge to shake Japan out of this torpor it has been stuck in for two decades, is quite remarkable.”

Justin Urquhart Stewart, co-founder of Seven Investment Management in London, agrees that Prime Minister Abe and the BoJ had little choice but to take dramatic action – which he describes as “more like quantitative dysentery than quantitative easing.”

“You have to look at it from the perspective of where Japan has come from in the last 25 years,” he says. “It has tried every other lever it can pull.”

Among macroeconomists, there is widespread understanding of what Abenomics is attempting to do, and of Japan’s unique predicament. “First and foremost is beating deflation, which has exacerbated Japan’s economic troubles over the last 20 years,” says Mark Allan, economist at Paris-based Axa Investment Managers. “Normally the role of monetary policy is to provide economic stabilisation when it is needed, but with Japan having been at the zero bound since the 90s, it has lost that element of monetary policy: every time an external shock comes along, the usual easing of policy isn’t possible in Japan.”

But is it working? “They are having some success at lowering real interest rates, though perhaps not as much as they might initially have expected,” Allan says.

Europeans assessing Japan’s success look at it in several ways: the movement in currency and markets; impact on Japanese growth; and the broader structural questions.

Markets and opportunities

From Europe, the market movements are the most visible effect. At first, market response seemed very positive: the yen fell very sharply, to the great benefit of Japanese exporters and to the equally great annoyance of Asian neighbours, and the Nikkei climbed dramatically. Then everything changed. “It seemed to be working,” says Beauchamp. “The sharp drop in the Nikkei has soured the impression that they were working some magic.”  At the same time, the yen has started to climb again. “The yen retains its safe haven element even with the sharp moves we’ve seen,” says Beauchamp.

But perhaps the bond markets have faltered most alarmingly, with yields rising very rapidly in late May. “When we saw the initial reaction to the announcement [on quantitative easing] at the beginning of April and yields fell very sharply, everyone expected the same kind of transmission as in the UK and US when they experimented with QE. But then things started to go awry in mid to late May, bond yields jumped, and there were concerns that the Bank of Japan had mishandled things.”

Since then, though, European investors have sensed some calm in Japanese government bonds. “It’s a question of looking at two opposing factors: the Bank of Japan explicitly and deliberately wants to raise medium to long term inflation expectations, and that implies higher bond yields,” Allan says. “But there is a dampening effect of the massive purchase program. Which is stronger?”

The positive view is that recent volatility is not indicative of a failure of policy, and is largely driven by issues outside Japan anyway. “I personally don’t read too much into it,” says Milligan. “Of course there has been volatility, but because of decisions not only by the BOJ but the Federal Reserve and People’s Bank of China, which have complicated matters.”

Investors are now surveying what has happened and working out whether Japan provides good opportunities or should be avoided. Urquhart Stewart sees no attraction in debt. “There are going to be such consummate amounts of it, it is not going to appeal to anyone at all,” he says. But on equities, the picture is different after recent declines. If, after the forthcoming Upper House elections in late July, Prime Minister Abe is given a clear mandate to see his policies through, and if there is a continuation of positive signs, “this will be good news for Japanese equities overall. Investors may start thinking it is time to go back into Japan at these levels.” Beauchamp at IG Markets agrees. “Stocks look more attractive than they did a few weeks ago. Investors should be looking for companies that will benefit from a weakening yen: exporters, and consumer goods.” Beauchamp expects the yen to continue to be talked down by the Bank of Japan, while Urquhart Stewart recommends international investors hedge any exposure to the yen.

Milligan says for investors, “the timescale matters enormously”, but that if the world economy does not get into further trouble and if Abe succeeds in pushing through structural reform, “you will find a lot of investors willing to move slowly back into Japanese assets again.” If that happens, he admires the fact that there will be a wide universe of stocks to consider across a range of sector. “If Abe does manage to revive the economy, there is a whole swathe of consumer, healthcare and REIT stocks that people will want to look at again.”

Staying the course and structural change

Nobody J-Money spoke to in Europe thought there was any chance of Japan changing course on its monetary policy. “You don’t get anywhere if you reverse course at the first sign of trouble,” Beauchamp says. And Urquhuart-Stewart adds: “I think Abe-san has to stay the course. I don’t think he has any choice. The alternative is far too humiliating, having set this path.”

As for the Bank of Japan, the change of personnel there – not just Kuroda at the top, but several of his deputies too – are seen as representative of a commitment to continue with easing. “The changes in the top leadership brought in a fundamentally different view of the nature of monetary policy,” says Allan. “Previous governors would say deflation was an intrinsic structural feature of the Japanese economy. Kuroda is a complete break from that. And that philosophical difference means the BOJ is not going to back track on its actions.” Indeed, if anything, he says the BOJ might actually get more aggressive.

Foreign investors and analysts agree on another point: that the monetary efforts of the last few months will not fix Japan unless they are accompanied by significant structural change as well. “The one issue no Japanese leader, including Abe in his previous time in government, has grappled with is the inefficiency internally in Japan, from the post office to the civil service to rice subsidies,” says Urquhart-Stewart. “If he is prepared to see those through, it will be very good for Japan.”

The problem is that there is a great deal of structural change that needs to take place. “Underlying competitiveness issues – high labour costs, rigid labour costs and poor demographics – will not be fixed easily,” says Elke Speidel-Walz, chief investment strategist for Germany at Deutsche Bank Private Wealth Management. “These structural issues suggest that deregulation and other reform will be necessary to lift Japan’s growth outlook.” She, like many other economists, is awaiting evidence that improvements in Japanese confidence earlier in the year is translating into hard data on growth and investment spending.

European investors feel that Prime Minister Abe has said all the right things about structural reform such as announcements about increasing the participation rate of women in the labour force, allowing more people to visit Japan, raising the status of universities and boosting innovation. “But headlines are easy: the difficult bit is overcoming vested interests who will lose out from those things,” says Allan. Like many others, he hopes the Upper House elections will be followed by “more information on quite how these structural reforms might work. Without them, the prospect of raising long-term economic growth is not very large. We are a bit sceptical, to be honest.”

There is also no doubt in Europe that Japan will face several painful challenges in the process of reform. Urquhart Stewart points out that the currency has been devalued at the same time that Japan has shut down its nuclear reactors, which brings a need for increased fuel imports which will now cost considerably more in yen terms. “Yes, they are right to do it, but the market is still judging whether it will work or not,” he says. Allan adds: “The big risk is in the labour market and wages. If inflation starts to increase, and VAT rises from 5% to 8% next spring as expected, there will be a significant hit to consumer spending, especially if there is no pick-up in wages. That brings the risk of a significant consumer-led recession in the middle of next year.”

Milligan at Standard Life, who also mentions the challenge of finding wage growth to avoid household income being squeezed, notes the complexity of what must be achieved in structural reform, covering so many sectors from agriculture to education, labour to health to trade.

On top of that, worries continue about Japan’s vast debt to GDP ratio, which stands at over 200%. “It’s clearly a worry, and these things can’t go on forever,” says Allan. “The question is when it stops.” And the question becomes more relevant as the nature of capital flows around Japan seem to be changing. It was a surprise to many when the Bank of Japan’s easing actions were followed by a repatriation of capital back home. If Japan is no longer going to be an exporter of capital, and instead has wider participation in JGBs and therefore less control over their yield, then the cost of interest payments on sovereign debt could rise. “Japan no longer has an excess of domestic savings it is exporting to the world,” Allan says. “If that continues and turns negative, importing savings from the rest of the world, the fiscal situation in Japan starts to look a bit more shaky.”

Milligan argues that debt servicing for Japan “is very manageable because bond yields are so low”, and says that “they can continue with their debt servicing for some time to come as long as they manage to avoid a sharp spike in JGB yields, and provided they manage to generate some growth.” And that is at the heart of Japan’s challenges: all of these measures may change bond yields, or revalue the currency, or deviate capital flows, but unless they create some growth in the economy, they will not be successful.