Waiting for Shinzo-man

Hopefully Shinzo Abe says, “High five for structural economic reforms!” Source: Getty Images News

Thursday, Japanese Q1 GDP rose 3.5% y/y annualized, easily beating expectations of just 2.7% y/y and for many, validating Japanese equities’ 20.7%ⁱ climb so far this year. These gains are likely at least partly the effect of arrows one and two of Abenomics—Japanese Prime Minister Shinzo Abe’s “three-arrowed” strategy to end the country’s decades long economic funk. However, in our view, sustained growth—and Japanese equity outperformance—from here will likely require Japan unleash the third arrow in the Abenomics quiver: Structural economic reforms—a task that’s proven too difficult for prime ministers in the recent past, Abe included.

Thursday’s GDP report confirmed Abe’s ¥13.1 trillion ($131 billion) stimulus package and the Bank of Japan’s (BOJ) 2% inflation-targeting quantitative easing (QE) effort (arrows one and two) have, at the very least, led to a short-term sentiment boost. Consumer spending jumped +3.7% annualized, perhaps as some consumers’ view of future price movement changed from the deflationary mindset of recent years. Exports grew +16.1% annualized, likely influenced in part by QE’s effect of weakening the yen (after all, eurozone exports grew in Q1 as well with no material weakening of the currency—implying accelerating global demand may have played a role). However, private capital investment dropped for the fifth consecutive quarter—potentially, a key sign of companies’ low expectations for continued future demand.

Of course, capital expenditures’ negative contribution was less bad than in recent quarters, but in our view, Japanese firms are likely awaiting meaningful structural reforms before committing to investment. Among myriad other factors, narrow labor markets, weak demographics, waning productivity, trade protectionism and a lack of marketplace competition have been huge impediments to Japan’s growth for some time. Japanese leaders have attempted to tackle these inefficiencies in the past; however, their inability to secure lasting popular support has led to little progress.

In our view, it’s likely Japanese firms have seen this story play out before and are cautiously holding off on investment. Recent prime ministers have enjoyed periods of popularity and pursued growth agendas, but most saw their popularity acutely decline, resulting in watered down and ineffective reforms. Abe enjoys a relatively high approval rating today, but so far he’s given little indication of forthcoming economic reforms beyond freer trade and utilities deregulation. His agenda to this point has been fiscal and monetary centric—popular with his constituents—with some flashes of nationalism. However, economic reforms, many of which will be directed at the labor market, are likely to be unpopular. Agricultural sector reforms will face headwinds from Japan’s powerful farming industry and restarting Japan’s nuclear reactors, closed since 2010’s Fukushima Daiichi disaster, may prove difficult, though rising energy costs could aid his effort. Then too, Abe’s obsession with amending Japan’s pacifist constitution and promoting a nationalist education agenda could prove a distraction, catalyze a decline in his popularity and derail any chance of economic reform.

So, while Thursday’s positive GDP report and recent equity market success might give reason for hope, Japan’s still got a long way to go. July’s upper house elections in Japan’s parliament could be telling. Should Abe’s Liberal Democratic Party (LDP) manage to secure control of the House of Councillors, it likely bodes favorably for his ability to push through necessary economic reforms. If the LDP doesn’t or Abe’s popularity suffers in the meantime, well ... history doesn’t repeat itself, but it certainly rhymes—and Abe could be on his way out the revolving prime ministerial door. Time will tell.