Worries voiced on Japan stagflation risks

Abenomics has been a great success so far, but market experts are questioning its sustainability amid signs that stagflation risks are starting to emerge, a forum heard in Tokyo this week.

So far so good was the general verdict from panelists in a debate on the effectiveness of Abenomics at AsianInvestor’s third Japan Institutional Investment Forum. (Last year's event had provided an initial view of Abenomics.)

Hiroki Tsujimura, chief investment officer at Nikko Asset Management, said Japanese share prices had risen by just 2.5 times in 30 years, as against 14 times for the MSCI World Index and 16 times for the US stock market.

What had changed, he said, was that prime minister Shinzo Abe had the firepower to tackle deflation, something previous governments have not been in a position to do due to political instability, with 15 prime ministers in the past 20 years.

From a domestic investor perspective, he said there was still a gap caused by a deflationary mindset, with Japanese investors having sold Y13 trillion ($127 billion) of domestic equities last year, while foreign investors bought Y15 trillion.

“For 15 years there was deflation in Japan, so the investing pattern is that when prices go up we need to sell,” Tsujimura said. “When prices did go up last year there was a lot of selling orders.” However, he said he expected this deflationary mindset to change greatly from this year onwards.

Takuji Okubo, chief economist at Japan Macro Advisors, noted that two consecutive years of GDP growth in the high 1% range had been achieved, delivering improvements in equity and real estate markets.

But he questioned the sustainability of Abenomics, opining that fiscal 2014 would see economic contraction on the back of a rise in VAT, combined with forecast wage growth of 1% and inflation of 3%.

“A stagflation type of risk is beginning to emerge in Japan,” Okubo told the room of asset owners, asset managers and service providers. “The real-term wage will go down by two percentage points, so consumption will lose significant momentum.”

While he acknowledged this had been factored in by Abenomics, he said forecast capital expenditure by corporations had no momentum. “A year from now we will probably see risk is on the rise,” he added.

Tsujimura countered that the Bank of Japan (BoJ) would likely act before stagflation was allowed to develop, adding that inflation would drive yen depreciation, which would be positive for share prices. “If share prices go up, there will be an asset effect, and that will stimulate consumption, so it [the threat of stagflation] can be offset to a certain extent,” he explained.

Yuji Kage, senior adviser at Blackstone Group Japan, said that portfolio performance had improved dramatically since Abenomics, especially for pension funds, which he said were close to resolving their underfunding problems.

What had changed was that containing negative growth in the equity market was no longer the main pillar of investment strategies, with long-term fixed income taking over as the chief risk to returns. “Over the mid- to long-term how you contain the fixed income risk may be the major focal point in investment strategies,” he argued.

While interest rates may rise, suggested Kage, there was little visibility as to when and how fast. Nevertheless, people are not gravely concerned at this stage due to the BoJ’s commitment to continue buying Japanese government bonds (JGBs).

He also noted that while the mega-banks had dramatically reduced duration over the past few years, there were few signs of such activity among other institutional investors. Rather they have been reducing domestic bond exposure gradually and raising overseas fixed income holdings.

“Investors are still adopting a wait-and-see attitude,” Kage noted. “How Abenomics takes root and how it develops is something people are watching very closely as they make gradual changes to their asset allocation. That is where they are today.”

Asked what would happen when the government raises the domestic consumption tax from 5% to 8% next month, transferring Y8 trillion to government coffers, Okubo was in little doubt. “There will be a drop in consumption and the economic growth rate will become sluggish. It will be stagnant for a certain period of time.”

While he said economists’ consensus was that growth would bounce back in the July-Sept quarter, he said he found no reason to believe that. He noted that the equity market was closely linked to profits in corporate sector, so that might mean equity prices begin to drop.

But Tsujimura forecast a minimal impact to stock prices, pointing to the relationship between share prices and the economy in the US, with the former high even as economic data not been positive due to unseasonably cold weather.

He added that BoJ governor Haruhiko Kuroda had pledged to intervene in the markets without hesitation if the economy took a turn for the worse, underpinning his confidence in the shares market.

Tsujimura also noted that most economists had forecast consumer price inflation of 0.5% for today, far below the 1.5% level it is at. His view is that Japan’s economic recovery is on track and that, while there would be some bumps along the way, it would moderately improve.

Okubo said there was more room for the BoJ to step in to buy more JGBs if necessary, in what he termed a “twist and forward” strategy.

With short-term rates unable to go further down, the only way to reduce risk would be step into the longer-term end of the market. Okubo noted that the BoJ was currently purchasing Y7 trillion in JGBs and that about Y500 billion of that could be shifted from a one-to-five-year duration to more than 10 years.

That was the twist section. The forward part referred to forward guidance to offset any volatility from any reduction in short-dated JGB purchases by the BoJ.

“By December this year Abe will have to decide whether consumption tax will be raised next year,” Okubo added. “He will come up with fiscal policy to offer tax incentives by lowering other tax rates, so there will be policy action for further economic expansion.”

The forum was co-sponsored by Eaton Vance Investment Managers and State Street Global Advisors, with associate sponsor Nikko Asset Management.