Tuesday, November 18th, 2014

Japanese Snap

Never pretend to expertise you don’t have: this is one of the golden rules of investment research. This column is about the impact of the Japanese election on the outlook for Japanese equities, but readers should understand at the outset that we cannot tell them what the election result is going to be. Our aim is to explain what’s priced into our asset allocation models as of now and what may happen over the next few weeks.

The decision to call the election was a surprise, as were the GDP figures for Q3 which showed a -1.6% decline against a consensus of over 2.0% growth. We think there is a significant chance that this figure will be revised upwards because it is heavily influenced by the data for corporate inventories which are (a) very difficult to estimate in real time and (b) may have been impacted in unpredicted fashion by the yen devaluation. This is important because when the final numbers are produced they may not show that the increase in sales tax killed consumer demand. It appears to us that Prime Minister Abe has learnt from Rahm Emanuel’s dictum “never to let a serious crisis go to waste” and decided to use this as a way of permanently prioritising economic reflation over fiscal sustainability.

We assume that Mr Abe and his faction of the LDP will win the election, if only because he assumes the same, and he would not have called the election if he didn’t. (Campaigning against tax increases – even if you proposed them – is normally a winning strategy). We also assume that the second round of the proposed sales tax increase will be postponed and that the reforms to corporation tax and the investment policies of government pension schemes (buying more equities) will go ahead because both are intended to be fiscally neutral. If not, the increase in reported earnings driven by lower depreciation charges and the stimulus to increased dividend distribution will both be at risk.

The decision to prioritise growth over fiscal sustainability cannot be good news for JGBs, but it doesn’t really matter because our yen-denominated model already had an 85% probability that equities would beat bonds on a risk-adjusted basis. Calling an election does not change the government’s intention to reflate the economy or investors’ expectations that it will succeed.

As far as international investors are concerned, gains on Japanese equities may be offset by losses on the yen, but this is hardly news, and they have already reacted positively to the intervention by the BoJ two weeks ago. Our asset allocation models in euros and in US dollars both rank Japan below US equities and above UK and Eurozone equities. As of this week they are ranked alongside Emerging Market equities, but the curves suggest that Japan is rising while Emerging Markets are declining. As soon as investors hedge their currency exposure Japan becomes our preferred equity region on a risk-adjusted basis, clearly ranking ahead of the US. We do not think the election changes our bullish view on Japanese equities (provided that the currency exposure is fully-hedged). The worst thing for investors would be for the Government and the Bank of Japan to expend so much ammunition and fail at the last hurdle.

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