Japanese stocks had a wild one last week, with most pundits’ attention focused on Wednesday. The Nikkei 225 Index blasted 7.7%[i] higher, as Prime Minister Shinzo Abe rededicated himself to economic reform and expressed optimism on the Trans-Pacific Partnership (TPP). For all the happy talk and happy stocks, however, little actually changed last week. Japan is still a struggling economy with deep competitiveness issues, and reform talk still vastly exceeds action. In our view, fundamentals don’t support Japan’s sentiment-driven rally, and better opportunities abound.
Abe’s comments followed his uncontested re-election as leader of Japan’s governing Liberal Democratic Party (LDP) on Tuesday. Stealing headlines was his vow to lower corporate tax rates by at least 3.3 percentage points next year, which sounds like a win for the country with the world’s second-highest corporate tax rate. But Abe’s pledge is nothing new—he’s only reiterating tax cuts already in the works. Japan cut corporate tax rates from 34.62% to 32.11% earlier this year, and they are set to decline to 31.33% next April. 34.6 minus 31.3 equals—drumroll—3.3! Abe did say he wants to cut beyond this, but that isn’t new either. His government approved much-ballyhooed plans to drop the rate “into the twenties” over the next several years, which could mean 20% or 29%. Current plans call for 29% by 2019, not exactly super competitive with much of the world.
Maybe investors were pleased to hear Abe focus on the economy again instead of national security, but talk is cheap. Abe has talked a lot about reform, but outside of taxes and corporate governance, he hasn’t done much, and even progress on those fronts remains short of what would most benefit Japan. Optimists might say the unopposed re-election shows Abe’s clout is at an apex, and this is finally “go time.” But Abe is now a lame duck[ii]. With no need to concern himself with re-election, he might be more willing to pursue reforms he shied away from in recent years, but Parliament may be less willing to support him. Prospective successors in the LDP may soon begin distancing themselves from his agenda as they jockey for their own leadership run in three years. That will make it harder for Abe to take on the vested interests blocking the most contentious items on his agenda, not easier.
The to-do list remains nearly as long as it has been since 2012, when Abe won a landslide promising to restore Japan’s dynamism, and Japan remains structurally uncompetitive. Lifetime employment hampers productivity and keeps many young people out of the workforce. Many businesses opt for lower paid temporary workers. A lack of childcare facilities keeps many women out of the workforce. Abe has vowed to tackle these and other labor market issues, but only minor tweaks have made it before Parliament—and fisticuffs broke out at one of the debates. Passing anything of substance will require Abe to spend a ton of political capital, which could in turn spur an early leadership challenge.
Other notable issues include Japan’s top-down, command and control agricultural system, which results in high costs and a lack of innovation. Agriculture might seem less significant, but farmers represent a big portion of the LDP’s base, and the agricultural lobby has big policy say-so. Taking them on is a litmus test for Abe’s broader reform chutzpah, and progress isn’t terribly encouraging. Despite Abe’s hankering to join the TPP, he has barely bent on high agricultural tariffs like the infamous 700%-plus rice duty and 300% markup on dairy, which speaks volumes. Abe has made progress on corporate governance and efforts to end the tangled web of cross shareholdings that prevents creative destruction from jolting Japan Inc. into the 21st century, but it remains to be seen whether new rules requiring firms to hire outside board members (among other items) are enough.
TPP—a 12-nation trade deal with the US and other nations on either side of the Pacific—would help with tariffs and other barriers, hence why markets seemed to cheer Abe’s optimism, but that is misplaced. In his speech, he said one more round of talks should be all it takes, but that seems optimistic considering those talks aren’t scheduled yet and other obstacles remain. After a series of talks, countries are still at odds over reducing tariffs on autos and dairy products, and the protection period for drug development and intellectual property also remain contentious issues. Beyond the difficulty inherent in getting 12 nations with competing interests to agree on such politically sensitive issues, there are administrative hurdles. Canada holds elections next month, and a less TPP-friendly administration could win, or gridlock could increase, jeopardizing finalization. US elections add another wrinkle. Free trade isn’t popular with voters these days, and leading candidates from both parties are jawboning about protectionism. It is hard to envision Congress passing something so charged in an election year, lest voters punish them for it.
Recent economic data underscore our skepticism. Japan emerged from a brief recession (its third since 2009) last year, but Q2 GDP fell -1.2% annualized as household consumption slumped -2.8%, private capex fell -3.6% and exports plunged -16.6%. Q3 is not getting off to a good start either, as July machinery orders dropped -3.6% m/m, compounding June’s -7.9% m/m drop—a bad sign for future business investment. Also, July real household spending fell -0.2% y/y and export volumes fell -0.7% y/y. And, while The Conference Board’s Japan Leading Economic Index rose 0.4% m/m in June, it is an outlier in a relatively lengthy downtrend—there aren’t many signs a big growth rebound awaits in Japan.
Japanese stocks look priced for perfection. They’re high on lofty expectations, and for Japanese markets to stay ahead, reality will have to follow suit. Anything is possible, but markets move most on probabilities, not possibilities, and the probability Japan meets expectations seems awfully low. In our view, it’s likely this mismatch leads Japanese stocks to underperform looking ahead.
[i] In yen. In dollars it rose 6.6%, which is big but not as big. FactSet, as of 9/11/2015.
[ii] While there are no term limits for Prime Minister in Japan, the LDL party imposes a two term limit for party leaders.