Japan: what is going on and how could this impact the markets?

Over the last few weeks Japan has grabbed the headlines, there have been some major changes to monetary and economic policy and this is having a big impact on the markets and could continue to do so for some time. We analyse the changes below.

Growth: Japan was plunged back into recession in Q3 after the economy contracted by a hefty 1.8%. The market had been expecting a 0.5% increase. In fairness, there were some bright spots in the report – exports and consumer spending made gains last quarter, however, they were not strong enough to offset the impact of a slump in the stocks of unsold goods, a sign that companies are unwilling to boost production. Residential spending was also weak. Unfortunately, there were not enough bright spots to boost Japan’s economic outlook, and there have been a wave of downgrades to growth both this year and next. One outcome of this weak patch for the economy is that the planned sales tax for next year has now been pushed back by 18 months to late 2016.

Economic policy: Prime Minister Abe announced the change in the timing of the next hike in the sales tax on Tuesday. On balance, this should be good news for Japan’s growth picture and could boost consumer spending. History tells us that Japan’s GDP tends to plunge when taxes are raised, so this delay could help return Japan to positive growth. Prime Minister Abe confirmed that he will stick to his “three arrows” policy of economic reform alongside stimulus, if he is re-elected after next month’s general election. He also announced that his cabinet are working on another economic stimulus programme to help dig the economy out of recession. These are all pro-growth measures, which should be good news for the Nikkei and help to boost USDJPY. Perversely, the yen can fall when the Japanese economy is doing well because it is considered a safe haven in the FX world.

Politics: PM Abe has called snap elections, he will dissolve parliament on the 21st November and the general election is expected to take place around the 14th December. Abe has called this election to get a public mandate to continue with his “three arrows” economic policy. Abe is expected to win by a large margin, so we don’t think that this snap election will trigger any political uncertainty. With Abe in power, we expect to see a continuation of policies that have weighed on the yen and boosted the Nikkei.

Bank of Japan: One of Abe’s three arrows is monetary stimulus. After being fairly slow off the mark, last month the BOJ announced an aggressive second round of stimulus totalling $12 billion plus, which should be much more impactful as it will likely result in the BOJ buying assets from pension funds and life insurers, who typically hold longer-dated bonds. The BOJ’s QE2 is expected to be more heavily weighted to bonds of 7-10 year maturities, which is more akin to Fed-style QE, and can help business confidence to grow, since the Bank is basically pledging to keep interest rates supressed for the long-term. This second round of stimulus was in the wake of a slight fall in prices for September, but if prices continue to fall then we could see QE3, maybe even QE4, down the line. The delay in the sales tax hike could weigh on inflation in 2015, since the 2014 VAT hike in April the CPI rate has more than doubled. A weaker yen could go some way to mollifying the downward pressure on inflation, however, oil prices have been falling sharply, which could limit CPI upside in the coming months. Thus, we believe that inflation could fall in the coming months and may even dip below the BOJ’s target of 2%, which could force them to take further action in Q1 or Q2 2015, which we think would boost the Nikkei and weigh on the yen.

The market impact:

Weak growth, a snap election and the prospect of further monetary stimulus should be yen negative, however because the yen is a safe haven, today’s announcement has actually triggered some sideways movement in USDJPY. This pair has rallied by more than 10% since the BOJ’s QE2 programme was announced in October, so a breather at this stage is to be expected. We still look for USDJPY to make it to 120.00- 121.00 by the end of 2014/ start of 2015, however, while we still think there could be further to go in the yen’s devaluation, beware of corrections when USDJPY starts to look overbought.

The Nikkei and USDJPY tend to have a positive correlation, as you can see in figure 1, with the Nikkei tending to rise on the back of a weaker yen as this helps boost exporters’ profits. The Nikkei has been mixed in recent days, but we continue to think that accommodative monetary and economic policy could trigger further gains. While domestic factors remain supportive for the Nikkei, the biggest risks are external – such as geopolitics or a sharp shift in Fed policy. The Nikkei remains some way off its record highs, and on a valuation basis, it is pretty even with the S&P 500 and the FTSE 100. If this strong correlation manages to hold, then a weaker Nikkei could correspond with USDJPY strength in the coming months.

Figure 1:

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