Economics and investment: Japan enters a new era

At the end of April, Japanese Emperor Akihito stepped down. Emperor Naruhito’s ascension marks the beginning of a new era; the question for investors is whether the new Reiwa era will bring any more joy than the turbulent Heisei era that preceded it. 

In the decades after the Second World War, Japanese growth was rapid. By the time Emperor Akihito came to the throne in the late 1980s, many were predicting the Japanese model would surpass that of the United States. The economy was dominated by close-knit industrial conglomerates that enjoyed tight relationships with their lending banks and produced world-beating exports, capturing large global market shares. The hype around Japan was similar to that around China much more recently. Asset markets became euphoric with equity and real estate prices soaring. 

In Japan, the late 1980s are now referred to as the bubble economy—and it burst spectacularly. The Nikkei 225 index of Japanese stocks is still around one third lower than it was three decades ago. As markets panicked, deflation set in, growth went into reverse and remained unreliable even after it returned. Government debt soared to 250 per cent of GDP. A banking and lending crisis was compounded by a demographic transition as the Japanese population aged. The word “Japan” re-entered the economic lexicon, this time as a dire warning of the future that might face the US and Europe in the aftermath of 2008. 

In reality, the case of Japan over the last two decades is more nuanced than the caricature suggests. Growth has been weak but unemployment never rose above 5.4 per cent, while inequality remained relatively low. Japan is also a useful reminder that demographics are not destiny. While the working population has been declining since 1995, social norms have shifted. Not only have people begun to work for longer but the economic participation of women has risen. 

Shinzo Abe, prime minister since 2012, has been determined to end deflation and set the Japanese economy on a more sustainable path to growth. What has become known as Abenomics is sold as having “three arrows”: monetary stimulus, fiscal stimulus and structural reform. Although in reality the second—and arguably third—of those has been kept in the quiver.  

On the monetary front, the Bank of Japan pioneered Quantitative Easing (QE). In recent years it has doubled down, with purchases of government bonds stepped up, along with the purchase of equities to support the stock market and interest rates cut into negative territory. Although deflation fears linger, Japan has finally managed to prevent prices falling further. 

Japanese markets have responded positively to Abe’s push. Equities have risen by an annualised 10 per cent since Abe took office. The real disappointment has been the failure to follow through on fiscal expansion. The Japanese state is highly indebted but interest rates remain exceptionally low and there is no imminent crisis of public finance. October’s planned hike in consumption tax will unhelpfully dampen consumer demand.

But overall, the Japanese economy is in a much better place than it was five years ago and that looks set to continue. Abe has every chance of completing the escape from deflation as long as the external environment stays relatively calm. The real risks to Japanese assets come from a more turbulent global environment and a potential escalation of the US-China trade war. For now, though, compared to other developed markets, Japanese assets look relatively cheap.

Read Andy Davis's investment report on the power of timing