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"Abenomics" and the outlook for Japan

April 07, 2014

Japan is called a "land of contrasts" so often that the label has become a cliché. But the description is not without a bit of truth. From the frenetic streets of Tokyo to ancient shrines amid forested hills, there is not "one" Japan—there are many.

These days, it's not just Western tour guides who speak of dramatic contrasts when they talk about Japan. Economists have sharply divergent views of the country too. Look back at headlines in the international financial media over the last year or so, and you'll see a disparate mix of stories about Japan. One day the news is upbeat; the next it's discouraging. One report brings hints of robust growth; the next warns of recession. One consumer survey heralds rising confidence; the next shows deepening anxiety.

Should you invest in Japan? Maybe you already do.

If you're a mutual fund investor, there's a good chance your portfolio already includes exposure to the Japanese market. Japanese companies such as Honda and Sony appear in the rosters of many global stock funds.

What's the proper allocation to a particular country? There's no right answer for all investors, but Vanguard suggests a starting allocation of about 20% to non-U.S. stocks, allocated based on each country's footprint in the marketplace. As of February 2014, Japan-based stocks accounted for about 8% of the total global equity market, compared to 49% for the U.S., according to Vanguard research.

Your personal allocation would depend on your goals, investment time frame, and tolerance for risk, keeping in mind both the short- and long-term trade-offs of international investing.

So, what's the reality? Amid the contrasts, what—if anything—is consistent about the outlook for the world's third largest economy?

Reading the tea leaves

"On the whole, the picture today is brighter than it has been in some time, but it's difficult to assess the Japanese economy in just a sentence or two," said David Cermak, director of Tokyo-based Vanguard Investments Japan.

David Cermak"One problem is that some of the leading indicators are in conflict," Mr. Cermak said. "You can make fairly persuasive arguments for a variety of economic projections, both positive and negative, based on the latest data. The lack of clarity is frustrating for analysts, policymakers, and ordinary investors, because so much is at stake here. Even though Japan has been in serious economic straits for the past 20 or 25 years, it's still one of the key pillars of the global economy.

"What happens in Japan," Mr. Cermak said, "has ripple effects in markets all over the world."

Consider some of those conflicting economic signals coming out of Japan in recent years:

Positive signs

  • Japan has the world's third highest nominal gross domestic product, behind the United States and China—$5.96 trillion in 2012, vs. $16.2 trillion for the U.S. and $8.2 trillion for China (source: International Monetary Fund).
  • Japan is the largest creditor nation, holding more than $3 trillion in foreign sovereign debt, including $1.3 trillion in U.S. Treasury notes (sources: The Wall Street Journal, October 2013, and U.S. Treasury, January 2014).
  • Japan boasts the second-highest total of privately held financial assets such as stocks and bonds—$19.5 trillion, vs. $58.9 trillion for the U.S. (source: Allianz Global Wealth Report, 2013).
  • Japan's unemployment rate is among the lowest in the developed world. As of January 2014, it stood at 3.7%, compared to 6.6% for the U.S., 7.0% for Canada, 7.2% for the United Kingdom, and 6.0% for Australia (sources: Japan Statistics Bureau, U.S. Bureau of Labor Statistics, Statistics Canada, U.K. Office for National Statistics, and Australian Bureau of Statistics).
  • Japan is home to 62 of the world's 500 largest companies (source: Fortune, 2013).
  • Japan's adult literacy rate is estimated at 99% and its students' reading and math test scores are consistently near the top of international rankings (sources: CIA World Factbook 2014 and OECD Program for International Student Assessment, 2012, respectively).

Negative signs

  • Japan's GDP growth is sluggish at best. In the fourth quarter of 2013, the economy grew just 0.2%, according to the government-run Economic and Social Research Institute. From 1992 through 2012, Japan's real GDP rose only 0.8% per year on average, compared with 2.7% for the U.S. and 10.3% for China (source: World Bank).
  • Relative to its GDP, Japan's public debt is the highest in the world. As of 2013, the Japanese government's net debt was almost 135% of GDP, compared to about 88% for the United States. Japan's gross debt (which factors out sovereign debt owed to Japan) stood at a staggering 237% of GDP (source: International Monetary Fund).
  • Japan's population, currently around 126 million, is falling, and is projected to decline dramatically in the next several decades. According to the World Bank, Japan's fertility rate (the number of children an average woman is expected to have in her lifetime) was 1.4 as of 2011, versus 2.1 for the United States. Coupled with a steadily rising senior-citizen population, the shrinking number of workers and taxpayers will impose severe strains on Japan's government budgets and its social welfare system.

"Abenomics" and the "three arrows"

After two "lost decades" in which Japan drifted in and out of recession, voters in 2012 reinstated the long-dominant center-right Liberal Democratic Party, which had been out of power since 2009. Former Prime Minister Shinzō Abe returned to office with a "three arrow" plan to reinvigorate the economy:

  • Arrow 1: Aggressive quantitative easing similar to that employed by the U.S. Federal Reserve. The Bank of Japan increased its purchases of government bonds and other securities with the aim of expanding the money supply, raising annual inflation to 2%, and weakening the value of the yen against foreign currencies in order to boost exports.
  • Arrow 2: Increased spending on infrastructure to create jobs and stimulate consumer spending. Soon after taking office, Abe unveiled a number of major public-works projects. Additional stimulus will likely come from the 2020 summer Olympic games, slated to be held in Tokyo.
  • Arrow 3: Structural policy reform aimed at increasing private-sector investment and improving economic productivity.

"The third arrow of Abenomics is arguably the most important, and it will likely be the most difficult to implement," said Roger Aliaga-Díaz, senior economist with Vanguard Investment Strategy Group.

Roger Aliaga-Diaz"As for arrows one and two, those are just regular monetary and fiscal policies," he said. "These types of policies, known as demand policies or stabilization policies in economic theory, cannot improve the long-term growth picture for a country. They're short-term policies aimed at stimulating economic activity, and they tend to work only when there are high levels of unemployment, which isn't currently the case in Japan."

When a country is stuck in a long-term stagnation—as Japan is—there are deeper structural problems on the supply side of the economy that need to be tackled, Mr. Aliaga-Díaz said. Only after those issues are addressed can Japan's growth be expected to increase sustainably above the 0.8% real growth average of the last 20 years.

GDP by country

Still, he said, Abe's demand-side stimulus programs may have at least one positive result: higher inflation.

"Positive, moderate inflation can help the Japanese government inflate its way out of its large nominal debt, which is held in large part by domestic investors," he explained. "When investors have a high degree of 'home bias' in their portfolios, higher inflation acts as a sort of tax, transferring real purchasing power away from creditors in favor of the sovereign debtor—the government. It's an effective way for a government to reduce its debt-to-GDP ratio."

Vanguard's recently issued white paper on the 2014 economic and investment outlook, which Mr. Aliaga-Díaz helped author, calls Abenomics "promising" but expresses doubt that GDP growth will exceed 1% in the near future.

"The main goal of Abenomics seems to be reflation of prices rather than real economic growth," the paper asserts. "Even assuming full success of its policies, by 2015 Japan would be growing at a pace not much higher than its average for the last 20 years. However, if successful, Abenomics would bring inflation to a significantly higher level than it has been in the recent past. This would be an encouraging development, although it will be a difficult task after two decades of deflation."

Japan's GDP growth and inflation: History and the outlook for Abenomics

Abenomics and inflation

Notes: Figure assumes that Abenomics achieves its goals of 2% inflation and 3% nominal GDP per capita growth by 2015. Transition assumes the International Monetary Fund's WEO October 2013 baseline is realized in 2013–2014. Sources: Vanguard calculations, based on data from Thomson Reuters Datastream and IMF.

A popular mandate ... but a cautious one

To date, the Japanese public appears to have embraced Abenomics—at least in principle.

The prime minister enjoys approval ratings over 60% (source: Yomiuri Shimbun, January 2014), and the Tokyo stock market has performed strongly since Abe's party regained power. Since he took office in December 2012, in fact, the Nikkei 225 Index is up more than 50% (source: Reuters, as of March 15, 2014).

Again, though, there are contrasting signs.

For example, consumer confidence, which had jumped immediately after Abe's election, slumped in recent months. The ESRI confidence index stood at 39.2 in December 2012, rose to 45.7 by May 2013, and had dropped back to 38.3 in February 2014. (A 50 rating is "neutral," meaning half of respondents have an optimistic view and half are pessimistic.)

"I don't see much 'irrational exuberance' on the streets of Tokyo," said Mr. Cermak. "People here truly do understand that the economic and demographic problems facing Japan are real, and that they need to be addressed directly if Japan is to remain in the first rank of the world's economies.

"That said, I believe there's a sense of optimism that things are finally turning around. You see that optimism reflected in the new construction that's taking place all over Tokyo, in the strength of the equity market, in consumer spending, and a number of other measures," he said.

"After so many years of economic drift, that sort of optimism—cautious though it is—is certainly welcome."



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