Prime Minister Shinzo Abe’s three-pronged economic recovery strategy — massive public spending, monetary easing and structural reforms — sparked optimism and enthusiasm in the minds of asset managers last year. They poured a record $43.7 billion into Japanese equities, according to EPFR Global, a fund-flow tracking service headquartered in Cambridge, Massachusetts, and the massive net inflows helped propel the Nikkei 225 index up nearly 57 percent — its largest annual gain in more than 40 years.
But many of those investors have been reversing course on concerns that Abenomics may be running out of steam. Meaningful reforms have yet to be introduced; Japan’s real gross domestic product grew by only 0.7 percent year over year in the final three months of 2013, below consensus expectations of 1 percent; and the government reported last month that in January the current-account deficit had swollen to ¥1.589 trillion ($15.5 billion). These developments, coupled with concerns that this month’s increase in the consumption tax will sharply constrain consumer spending, have sent many portfolio managers in search of safer havens. The Nikkei tumbled about 12 percent in the first ten weeks of the year.
“Recent pessimism about the Japanese stock market is overblown,” insists Yohei Osade, global head of pan-Asian equity research at Mizuho Securities Group. Investors sold a net ¥975.3 billion in Japanese stocks in the second week of March, he notes, and that’s “more than they sold during the global financial crisis and second only to Black Monday in October 1987.”
The pullback was prompted by disenchantment with Abenomics and worries about the impact of the tax increase, among other issues, Osade acknowledges. “That said, it could hardly be argued that Japan’s economy or corporate earnings are in a worse state now than at the time of the Lehman shock,” he adds.
Jun Konomi, Nomura’s head of Asia-Pacific equity research, holds a similar view. “Some investors have become a bit skeptical about Abenomics, and that’s led to the recent malaise in stock prices,” he says. “But we believe both the GDP slowdown and sluggish stock market are temporary and attributable to the scheduled tax hike, dollar-yen sideways trading and geopolitical risks. We are going to see a powerful resilience in the economy and the market.”
Or not, according to Mitsubishi UFJ Morgan Stanley Securities Co.’s Nobuyuki Saji. “This is showing the structural downturn of the Japanese economy,” the famously bearish economist declares. “Through the first half of fiscal 2013, Japanese consumers had enough expectations for the future under Abenomics that the economy gradually improved. However, with the current yen depreciation [driving up] commodities prices, the optimism has ceased and buying sentiment has cooled.”
Can it be rekindled in fiscal 2014, which began April 1? Much depends on how Japanese consumers react to the tax increase as well as the prime minister’s success in implementing the reforms he promised more than a year ago. Investors will be watching closely, and many of them will be counting on insights from the sell side. When it comes to providing the direction that money managers find most helpful, they say, Mizuho and Nomura outpace the competition. These firms share top honors on the 2014 All-Japan Research Team, Institutional Investor’s 21st annual ranking of the country’s best sell-side analysts, by capturing 24 team positions each. That’s the same number that Nomura claimed last year, when it was the team’s sole leader, but for Mizuho it represents an increase of nine — including six sector-topping analysts, more than from any other firm. Indeed, when positions are weighted to reflect their relative values, Mizuho (which finished third overall in 2013) emerges as this year’s undisputed champion, with a weighted total of 64 to Nomura’s 54. (See Weighting the Results.)
SMBC Nikko Securities also makes a laudable jump, from No. 5 to No. 3, after increasing its team-position total by five, to 19. Bank of America Merrill Lynch falls from second place to fourth after losing two spots, leaving it with 16, while Daiwa Securities Group holds steady at No. 5 with 14 positions. These results reflect the opinions of more than 1,000 investment professionals at some 350 buy-side institutions that collectively manage an estimated $1.1 trillion in Japanese securities.
See the top-ranked analyst in each of the survey’s 33 sectors in the navigation at the top right of this page, along with profiles of these individuals and of those in second and third places, plus a list of runners-up and other survey data.
Saji, a member of the All-Japan Research Team Hall of Fame who’s making his 13th appearance at No. 1 in Economics, believes that the sales tax, which jumped from 5 percent to 8 percent this month and is scheduled to rise to 10 percent in October of next year, “can push down real GDP growth by 0.45 percentage points in fiscal 2014 and by 0.75 points in fiscal 2015.” Moreover, “there are two additional tax increases, both starting from January 2015, raising the maximum rate of inheritance tax and cutting its basic exemptions, and raising the maximum income tax rate,” he points out. “These can be heavy burdens.”
As for Abe’s “third arrow” — structural reforms — the prime minister is facing tough opposition from his own Liberal Democratic Party, which favors “putting tax hikes on working households to maintain current generous social security systems,” Saji says. “It is unlikely to implement policies that can raise the unemployment rate even in the short term or that can give advantages to corporations rather than individuals. These can be materialized after 2016,” the deadline for the next general election.
Others have a more sanguine outlook. “The consumption tax hike will lower Japan’s growth in fiscal 2014 by 0.7 percentage points, in our view, primarily through lower real income of consumers,” Nomura’s Konomi predicts. “However, the government’s supplementary budget and front-loaded spending of its fiscal 2014 budget will likely mitigate the negative impact, as will an expected increase in corporate investment and exports.”
Sweeping changes, meanwhile, “are likely to materialize over time,” he adds. “We have already started to see new entries to the power market following the new law to liberalize the electricity market. Reform in each area may not amount to much, but those initiatives should collectively raise growth.”
Kazuharu Miura, head of equity research at SMBC Nikko, agrees. “The negative impact from the consumption tax hike on consumer spending and GDP can be offset by the positive impact of the economic stimulus package and wage increases,” he believes.
It’s helpful to remember that the last time Japan’s sales tax was raised, on April 1, 1997, the Nikkei sank to a low on April 10 before rebounding roughly 16 percent by mid-June of that year, Mizuho’s Osade stresses. “We forecast a similar rally this time, provided the contraction of demand after the current spike is within expectations,” he adds.
His colleague Masatoshi Kikuchi, who reclaims the top spot in Equity Strategy after a year in second place, believes a consumer spending slowdown will be limited to Japan’s fiscal first quarter. “The stock market should recover once investors recognize that slowing demand is temporary, from April to June, and should start to pick up in July,” he predicts. “We upgraded the retailing sector from underweight to neutral on March 20, as we think the bad news is already priced into retailing stocks.”
There could even be an upside for consumers, according to the No. 1 analyst in Retailing, Hiroshi Koba of Mitsubishi UFJ. “The fallback from front-loaded demand will likely be limited both in terms of scale and duration, but it could spark price competition in some markets,” says Koba, who tops the roster for the fifth time in the past seven years. His top pick is Saitama-based home improvement retailer Shimachu Co. “Teaming up with furniture manufacturers has made it possible for the company to add relatively high-end products to its lineup, and the furniture market has turned slightly in Shimachu’s favor, with the weaker yen making it harder for low-priced furniture importers to compete on price,” he explains. “However, one risk we see is a significant slide in consumer appetite for durables once the tax hike kicks in.”
That’s less of an issue insofar as consumer staples are concerned. Naomi Takagi, the top-ranked analyst in Beverages, Food & Tobacco for a third year running (and for the fourth time since 2010), observes that shoppers stocked up on essentials ahead of the tax increase. As a result, “volume will be down from April to June,” the UBS analyst asserts. “However, consumers may be more selective about brands, quality and value once the prices go up.”
Some companies are introducing new products to increase margins, she reports. For example, Asahi Group Holdings, a beverage distributor headquartered in Tokyo, and its crosstown rival Suntory Beverage & Food have added premium labels to improve their sales mixes, Takagi notes.
Other retailers may raise prices above and beyond the amount called for in the tax increase. “The government is warning against opportunistic pricing at this time, as they fear a slowdown in spending,” the analyst explains. “At the same time, the government is suggesting strongly that companies add the higher tax to product prices rather than try to absorb it.”
The weak currency is also adding to the troubles faced by many food and beverage providers, which procure between 70 and 80 percent of their raw materials from overseas, Takagi notes. “My sector will not perform well in the current environment,” she states. If the yen would stay at its current level, 102.45 against the dollar as of mid-March, “then the cost increases would slow down in the second half,” she says.
But that’s not going to happen, according to Deutsche Securities’ Taisuke Tanaka, who captures first place in Currency & Foreign Exchange for a second consecutive year. The steadily improving U.S. economy will spur further devaluation of the yen, which will likely reach 115 against the dollar by the end of this year and 120 by the end of next, he forecasts.
“We see U.S. GDP growth of 3.2 percent in 2014 and 3.8 percent in 2015,” Tanaka says. “Without a strong U.S. economy, the dollar will not be able to appreciate [against the yen] even if the Bank of Japan does additional quantitative easing.” And if the U.S. recovery is weak, any additional measures by the Japanese central bank will be not be able to make the dollar — and the Nikkei — move higher, he adds.
“We are always watching risk-off triggers such as disappointing U.S. growth; shocks from China, the euro zone or emerging markets; and geopolitical issues,” Tanaka reports. “In our main scenario, however, these risks are not seen as significant at the moment.”
The prospect of further monetary accommodation is a key issue for banks. Nana Otsuki, who claims her first appearance at No. 1 in the sector, believes that “additional measures may be implemented between July and September, and the impact on the banking industry would be mixed.” Such easing would strengthen expectations for a rise in the consumer price index, which would encourage corporates to increase capital expenditures, the BofA Merrill researcher points out. Before this happens, however, the Tokyo Interbank Offered Rate may experience further downward pressure, which could lead to deterioration in financial firms’ net interest margins, she adds.
“We currently have a neutral or slightly cautious view toward the Japanese banking sector,” Otsuki says. “From the middle of this fiscal year through the next, we could become more bullish, given that we may see some top-down and/or bottom-up catalysts. The market may start factoring in a possible turnaround of net interest income around the first quarter of fiscal 2016.”
The increase in the consumption tax is likely to have little direct impact on banks’ profitability, she says, but could adversely affect mortgage-loan demand, after the short-term rush into that market leading up to the hike. “In the end the impact should not be large, as long as people believe that property prices will remain solid going forward,” she contends.
The dawn of a new fiscal year has brought other developments that seem likely to have a more positive — and longer-lasting — impact. In late March, for instance, the government unveiled a proposal to allow more foreign workers into Japan and to permit them to stay for five years, rather than the current three. “Most investors have been unaware of developments concerning immigration policy, such as proposed revisions to the immigration control act, mainly because there has been little media coverage on the subject outside Japan,” says Mizuho’s Osade. “We thus believe the surprise factor will be considerable if changes are made.”
However, it will be some time before any policy changes can be implemented, Kikuchi believes. “The report is good news in the longer term for the construction and other industries with labor shortages, and by extension for Japan’s economy as a whole,” the Mizuho strategist says. “But the need for legal changes before any of these proposals can be put into practice means they will not take effect until fiscal 2015.”
Even so, “the recommendation that Japan accept larger numbers of skilled foreign workers is a positive indication that the country is willing to join the international competition for highly qualified people, even if it is late into the race,” he adds.
Also in late March the administration identified a half dozen national special strategic zones — areas that will serve as testing grounds for economic deregulation. “The National Strategic Special Zones Act differs from similar initiatives in the past in that its aim is to make Japan’s large cities even stronger and that it is directly administered on a top-down basis by the prime minister and central government,” Kikuchi explains. “In this sense we believe it has the potential to drive regulatory reform.”
He notes, though, that the announcement came nearly three months late, having been delayed “by resistance from bureaucrats and industry bodies that do not welcome regulatory reform, and by heavy lobbying from politicians keen to bring such zones to their constituencies.”
An even more contentious issue is the corporate tax rate. The prime minister has frequently expressed his desire that it be cut from its current level of approximately 35 percent, which is among the highest among developed nations, to help make Japanese companies more globally competitive and to attract foreign investment. Critics of the plan — including members of Abe’s own party — have argued that any reduction will hamper the country’s ability to pay its public debt, which at more than 240 percent of GDP is the highest in the world.
“Concerning the corporate tax rate cut, some investors optimistically expect a rate of 25 percent, while others more cautiously look for 30 percent, but in either case the corporate tax cut being discussed will do nothing to lift investors’ expectations until debate proceeds to action,” Osade contends. “Our impression is that much depends on whether the government presents specific figures and a time line when it gives a growth strategy update in June.”A more urgent consideration is the Trans-Pacific Partnership, a proposed free-trade agreement among Japan, the U.S. and ten other countries. The negotiations have stalled over disagreements stemming from Japan’s insistence on protective tariffs on certain agricultural goods. The U.S. wants all such preferences eliminated.
“People close to the Trans-Pacific Partnership talks have talked of trying to reach an overall agreement in time for President Obama’s visit to Asia in late April and ahead of the U.S. midterm elections in November, but are pessimistic about the chances of success,” Osade says. “This would not come as a negative surprise to the stock market, which has already formed a consensus that an early agreement is unlikely. We believe that the Abe administration can still succeed in its economic agenda, but failure on the Trans-Pacific Partnership would be bad news in the medium term in that it would delay one of Prime Minister Abe’s ‘third-arrow’ reforms: overhauling Japan’s farm sector.”
The government has identified certain product groups — including beef and pork, dairy, rice, sugar and wheat — as key exports that must remain tariff-protected, he explains. The goal of the partnership is to achieve near–100 percent tariff removal, but the figure would slip to 93.5 percent if these five categories were exempted.
The U.S. is prepared to view rice as a special case but is reportedly pressing for major reductions in the levy on beef — which it regards as a strategic export — from the current 38.5 percent, Osade says. “The media have also reported a work-around being floated by the Liberal Democratic Party, under which Japan would nominally fulfill its international commitment by lowering tariffs on some of the 586 individual items within the five protected categories,” he adds. “It is reportedly considering which of those items to sacrifice — but we only have such media reports to go on, since details of the partnership talks are not disclosed.”
Other research directors downplay the importance of the agreement as well as the need for urgency. “The Trans-Pacific Partnership is an important initiative for growth but is still just a part of the overall strategy,” observes Nomura’s Konomi. “Even if the agreement fails to materialize in 2014, it will have a good chance in early 2015, after the U.S. midterm elections.”
SMBC Nikko’s Miura concurs. “The partnership is a part of Abe’s growth strategy, but the importance is not so high relative to the economic special zones and corporate tax reduction.”
True to form, Saji holds a contrarian view. “There will be no success in Abenomics without the conclusion of the Trans-Pacific Partnership,” the Mitsubishi UFJ economist declares. • •
