More than a nominal victory

Written By: Simon Cox Managing Director and Investment Strategist BNY Mellon Investment Management, Asia Pacific

& Miyuki Kashima Head of Japanese Equity Investment Division BNY Mellon Asset Management Japan

Abenomics has rescued Japan from two decades of deflation, and the implications for the economy and investors could be far reaching. Simon Cox and Miyuki Kashima of BNY Mellon look at the main issues involved

Japan was one of the best performing major stockmarkets in 2015 – even in dollar terms. That surprised many critics of Abenomics, the campaign to reflate Japan’s economy named after Shinzo Abe, prime minister for the past three years. Abenomics has entailed aggressive monetary easing, some reshuffling of taxes, and piecemeal structural reforms, including improvements in corporate governance, with the aim of lifting spending, wages and prices. According to conventional wisdom, progress has been mixed at best. Growth has been choppy and headline inflation remains low. According to its critics, Abe’s signature policy has succeeded in weakening the currency, but little else. As 2015 began, many investors believed that Japanese share prices might rise in response to further easing from the country’s central bank. But they assumed that any local-currency gains would be offset by yen falls.

As it turned out, the Bank of Japan kept its monetary policy largely unchanged in 2015 (with the exception of a December tweak in the maturity of its bond purchases and the size and scope of its ETF purchases). The yen ended the year almost flat against a strong dollar. Despite this, share prices rose by over 9%. A weak yen, it seems, is not the only strength of Abenomics.

Although it has been overshadowed by its giant neighbour, Japan remains a prosperous, sophisticated country. Indeed, judged by the diversity and exclusivity of its exports, it is the most sophisticated economy in the world, according to a measure of economic complexity devised by Ricardo Hausmann of Harvard University and Cesar Hidalgo of the Massachusetts Institute of Technology. Doomsayers like to talk about Japan’s mountainous public debt. Less often discussed is the country’s impressive stock of national wealth, which amounted to 635% of its annual GDP at the end of 2013, according to a comprehensive measure by Japan’s Cabinet Office. That figure includes real assets like land and property, as well as the world’s largest stock of net foreign assets, which exceed even China’s.

Japan’s equity markets still account for almost 9% of the widely-followed MSCI World index. Those markets also seem to offer substantial diversification benefits to global investors: in a 2014 comparison of 16 developed-country equity markets, Japan’s was the least correlated with the rest of the world’s markets. The authors of that study¹ went on to construct a stylised portfolio of global equities that seeks only to maximise the benefits of international diversification. In such a portfolio, Japan would warrant a weight of over 20% in the most recent period studied.

Despite these virtues, Japan has suffered from a peculiar macroeconomic predicament over the past two decades. Thanks to stubborn deflation, its nominal GDP (the yen value of its annual output, without making any adjustment for changing prices) has remained more or less flat for over 20 years. It was about 500 trillion yen (at an annual pace) in the third quarter of 2015 (the latest figure available at the time of writing) and it was much the same amount in the third quarter of 1994. This flatness is a macroeconomic oddity: it is hard to find another economy quite like it. Even a country like Italy, which is often portrayed as sclerotic and greying, nonetheless managed to almost double its nominal GDP over a similar period.

The unbearable flatness of Japan’s nominal GDP is not because real growth has been terribly weak. The economy has enjoyed periodic gains in real output over the past two decades, most notably the Koizumi boom before the global financial crisis. Nor is Japan’s stagnation simply the inevitable result of demographic decline, although that has not helped. The failure of Japan’s nominal GDP to grow is instead the consequence of chronic deflation. If, instead of falling, Japan’s prices had risen by just 2% a year over the past 20, its nominal GDP would now be over 70% higher than it is, all else equal.

Why does this nominal flatness matter? Surely people only care about “real” variables, like real GDP and real wages, which strip out the effect of changes in prices. In our view, however, the stagnation of Japan’s nominal GDP has inflicted insidious damage on the real economy. It has distorted corporate behaviour and household sentiment, as well as enlarging Japan’s debt burden and neutering its monetary policy. In many ways, Japan’s nominal GDP feels more “real” than the inflation-adjusted number. If pay packets are getting thinner, households will feel inhibited in their spending, even if shopping bills are also shrinking. Likewise, if corporate revenues are contracting in nominal terms, bosses will be reluctant to borrow and invest, even if wages and costs are also falling. In the deflationary era, Japan’s corporations have proved to be inveterate hoarders, accumulating over 1 quadrillion yen in financial assets, including cash, rather than investing in capital expenditure, paying higher wages, or returning profits to shareholders.

Thankfully, this long period of nominal stagnation appears to be ending. Although headline inflation remains low in Japan, that is largely the result of falling energy costs. Remove energy as well as fresh food from the index and consumer prices have clearly turned around since Abenomics began. About two-thirds of the items in Japan’s consumer basket are now becoming pricier, including ketchup – to cite one famous example – which has risen in price for the first time in 25 years. [The official index may also understate the turnaround because it is slow to reflect changing consumption patterns. A more timely index, based on point-of-sale data in stores, published by Nikkei and the University of Tokyo, suggests consumer prices rose by almost 1.3% year-on-year in December.]

The end of deflation, coupled with fitful real growth, has begun to rouse Japan’s nominal GDP out of its long slumber. Indeed, over the entire period since Abe returned to power, nominal GDP has grown at its fastest rate since 1997. That increase in the yen value of Japan’s national spending has contributed to a vigorous recovery in corporate profits since 2012, which has outpaced the rebound in share prices.

If corporate Japan continues to park those profits in the bank, they will do little for the economy or outside investors. But the return of inflation will make hoarding a less appealing strategy. Abenomics is also nudging firms to provide more generous dividends or share buybacks through corporate-governance reforms. Both the Bank of Japan and the Government Pension Investment Fund, the world’s largest public-pension fund with over $1 trillion in assets under management, have promised to invest more heavily (directly or indirectly via ETFs) in the JPX-Nikkei 400, a stockmarket index that showcases firms boasting a strong return on equity and shareholder-friendly corporate governance. That should encourage Japan’s corporate hoarders to do something more interesting with their enlarged profits. And that bolder corporate behaviour should, in turn, make Japan a more interesting prospect for global investors.

1. Peter Christofferson of the University of Toronto; Vihang Errunza of McGill University; Kris Jacobs of the University of Houston; Xisong Jin of the University of Luxembourg