Japan’s momentum trade
The combination of a broadly stable macro-economic backdrop, plentiful central bank liquidity and low market volatility has been kind to investors this year. The year-to-date performance of most major equity markets has converged, regardless of any divergence in fundamentals or profit trends. If nothing rocks the boat, there is no reason to believe that the current momentum cannot continue. In that case, will Japan, which lagged other major markets over the first few months of the year but which has begun to play catch up in recent weeks, be able to sustain its rally?
We are skeptical about claims that ‘this time is different’ for Japan. Despite all the hype surrounding prime minister Shinzo Abe’s promises of reform, so far little has been done that raises Japan’s potential growth rate. Nevertheless, the Japanese market offers tactical opportunities aplenty.
Against the current global backdrop — with decent global growth and a modest inflation trend, together with a group of central banks (including the BoJ) ready to act at the first signs of trouble — Japan does not need to do much to keep its rally going. A confirmation that the economy isn’t falling out of bed would probably be sufficient.
Over the first few months of 2014, the Nikkei decoupled from one of its most reliable indicators, underperforming relative to an index composed of the yen’s exchange rates against the US dollar and the euro. The sell-off in equities over the first four months of the year despite the yen’s stability reflected investors’ concerns that April’s hike in the sales tax rate could lead to a repeat of 1997, when Japan sank into recession following an earlier sales tax increase.
But as we have pointed out before, Japan has learnt its lesson. The 1997 tax hike was accompanied by a withdrawal of other stimulus (like healthcare benefits) which together took JPY 9trn out of consumers’ pockets. This time around Japan has offset the pain with temporary fiscal relief. The negative effects of the 1997 tax hike were also magnified by the impact of the Asian crisis. Now, however, Japan’s neighbours have mostly repaired their balance sheets. And although China has accumulated a lot of domestic debt, there is no obvious trigger for a systemic crisis. Instead, the effect could even prove positive for Japanese equities, as a gradual reduction in China’s growth potential will help to cap global inflationary pressure, facilitating the global momentum-driven party.
In truth, the Japanese economy shows no signs of falling out of bed. The indicators are all pointing to the same message: the worst has passed. Last month, consumer sentiment registered a month-on-month rise having slumped for six months in a row.
In May’s Economy Watchers Survey the diffusion index for current economic conditions improved to 45.1 from 41.6, suggesting that the negative impact of the consumption tax hike may be short-lived. The survey’s outlook for the next two to three months also rose, reaching 53.8, its second month in a row above 50. For investors, the question now is whether the rally can continue as the equity market catches up with the currency indicator. It would be too much to expect a weakening currency to propel further gains, as signs that the economy has bottomed out mean the BoJ will be more likely to sit on its hands. So will the stock market be able to break its tie to the yen once again, this time on the upside? Possibly. A corporate tax cut to below 30%, due to be announced this month, could be one promising trigger.