Japan: New hand on the tiller

“Speculation has focused on whether or not this makes it easier for incoming governor Ueda to do away with YCC completely,” says Tony Roberts, a fund manager for Asia Pacific equities at Invesco. However, for him the implications of this are limited. Yields are now back below the upper band and Japanese banks tend to lend at the short end of the curve.  “More meaningful would be an end to the negative interest rate policy. With inflation above target, albeit moderating, this is a possibility. Any move here could see Japanese money coming home and the yen strengthen.” 

In Nikko Asset Management’s view, no decision is likely to be made on widening the YCC bands until July at the earliest. “The yen has returned to a much more stable level, and global economic growth looks set to decelerate further,” according to John Vail, global strategist at Nikko. He also points out that Japan’s demographic and general economic profile is “conducive to very low inflation, if not deflation, and the odds that overall wages will continue to rise above 2% in 2024 are quite low”. He notes that labour mobility is very low in Japan, except in a few select job-sectors, as employees are loyal, and corporations prioritise automation. 

Imminent change unlikely

According to Vail, while Ueda advocates a more actively traded, free market-style bond market and monetary policy, “when the possible negative ramifications of actually implementing such [policies] are highlighted, then hesitancy arises. Japan’s economy would be hurt if bond yields rise above the current cap, as would the country’s fiscal deficit”. 

Ueda is therefore unlikely to advocate any change until he is quite sure that bond yields have settled at a low and stable rate and that the economy is likely to perform adequately in the quarters ahead. Especially as the last two times the BOJ hiked its policy rate recessions followed and the governors at those times were accused of making a policy error.

Tom Kynge, deputy fund manager at Sarasin & Partners, expects the programme “to be replaced by a vague quantitative easing policy which will seek to calm investors and financiers that government bond rates at the longer end of the curve will not be allowed to rise unchecked. This is likely to be communicated as an incremental adjustment and not as policy tightening”.

According to Vail: “Some market experts believe that moving the bands to the 5-year bond from the 10-year bond is possible, but simply shifting the market-distortion does not seem that helpful, other than to the hedge funds that are shorting 10-year bonds.”

Kynge agrees: “We do not think that owning long-dated Japanese government bonds is attractive at this stage.”

“Marginally tightening BoJ policy, abandoning YCC, would undoubtedly be negative for economic growth,” says Kynge. 

Consensus expectations of economic growth in Japan are for a return to trend of roughly 1% over the next few years, but he notes: “The outlook is uncertain. On the one hand, a reopening Chinese economy should benefit Japanese manufacturers that export factory equipment and technology products to China’s vast manufacturing sector. On the other hand, inflation at a multi-decade high and expensive energy costs are squeezing Japanese consumers and manufacturers, disincentivising spending.” 

In some ways Japan’s economy has followed the same COVID-induced business cycle as other developed economies in recent years, but Trevor Greetham, head of multi asset at Royal London Asset Management, notes it has its own economic idiosyncrasies. “A rapidly ageing population means trend growth in Japan is low, and it’s easy to bump down into negative territory,” Greetham says, but he adds: “Recent data has been encouraging, with business surveys pointing to a gradual recovery this year. Negative real pay growth, a common challenge, is offset by the prospects for stronger growth in exports to China.”

Enough to lure foreign money?

The foreign buying witnessed in the Abenomics period of Shinzō Abe’s premiership from 2012 to 2020 has reversed more recently. Uncertainty surrounding BoJ policy and a record cheap yen, thanks to the divergence in monetary policy, seems to act as “a roadblock for the foreign investor,” according to Emily Badger, portfolio manager at Man GLG.

Then the tweak in monetary policy in December was perceived as the beginning of monetary policy normalisation in Japan, and it certainly took the equity market by surprise. The performance of Japanese financials in response was extraordinary. In December 2022, the TOPIX bank sector had its best month of performance relative to the wider market since January 1987. Outperformance continued through the opening weeks of 2023 as global investors piled back into Japanese financials. With this improving sentiment, the index broke out to a new high on 9 March. 

Then came the news from the US that Silicon Valley Bank (SVB) was facing a capital crisis. Badger says: “There is no suggestion that the Japanese banks are vulnerable to the same liquidity risks recently experienced by their US and European counterparts, but with this month’s stark reminder of the risks that bank stocks can face, the market’s enthusiasm for the monetary policy normalisation trade has also tempered.” In the Japanese market a violent rotation from value to growth and a flight to defensives and tech ensued. 

Longer term, Badger believes policy normalisation “will be positive for Japanese equities, and particularly for Japanese value stocks”. The valuation of the overall Japanese market remains low, particularly relative to the US. The Topix 12-month forward P/E is around 13x, close to a 10-year low.

For Greetham, it is all about the yen. Japanese equities are “highly sensitive to the level of the yen, given the high weighting of exporters in stock market indices”. The yen will continue to be driven by international developments, typically weakening when US interest rates rise and strengthening when they fall. Greetham says this makes the Japanese stock market “something of an ‘anti-bond’, doing relatively well in local terms in years when bond yields rise”. 

He adds: “The flip side is we expect Japan to underperform as the [US Federal Reserve] pivots and moves to cut interest rates.”

However, Roberts at Invesco concludes: “Japan offers political stability and good governance in a region where geopolitics often moves markets. It also has a large number of globally competitive companies whose fortunes are less tied to the Japanese domestic economy.”