Investing in Japan

Written By Brian Hicks

Posted October 7, 2014

During his campaign for the premiership, Mr. Shinzo Abe brilliantly captured his policy plans as consisting of three arrows.

The first two arrows of “Abenomics” — a huge fiscal stimulus and more expansive monetary easing — were the easy part. His approval rating soared, as did the stock market, while his party (LDP) was victorious in an election for the upper house of the Diet, Japan’s parliament.

The yen’s drop helped fuel a 23% surge in the benchmark Nikkei 225 index in 2012, followed by a 57% jump last year — the biggest annual gain since 1972.

In early 2013, seeing a dirt-cheap Japanese market and the bright prospects for then-candidate Shinzo Abe, I began recommending the “Merrill Lynch of Japan,” Nomura Securities (NYSE: NMR). In only four months, Nomura jumped 133%.

No question Japan’s industrial exporters have made a strong comeback as well. Net income from Japan’s major corporations surged 69% in the fiscal year ended in March, while manufacturing profits rocketed 116%.

This is all great news, but Abe’s third arrow — massive structural reforms to Japan’s economy — is the linchpin to a lasting bull market.

And despite the fact that many in the financial media accept the party line that reforms are already underway, this third arrow faces deep skepticism.

The reason for this is an important aspect of Japanese politics that I learned about as a student in Japan: the gap between what appears on the surface (tatemae) and reality (honne).

The Reality

The reality is that this third arrow faces gale-like demographic headwinds as well as the opposition of fierce and powerful interest groups. And the weak yen policy is now beginning to hurt rather than spur economic growth.

Let’s look at what the proposed third arrow of market reforms looks like and assess the chances of success.

The upcoming economic reform proposals are expected to include a reduction in Japan’s high corporate tax rate. But this will be offset by Japan’s VAT, which already rose to 8% in April from 5% and is scheduled to rise to 10% in October 2015.

The IMF recommends a further increase to 15%, income tax increases, or reductions in pensions (like U.S. Social Security).

Only minimal reforms are expected on immigration, energy, labor markets, retail, and agriculture. New data shows only 1.03 million babies were born in 2013, pointing to a decline in Japan’s population from the present 127 million to 87 million in 2060 (with 40% over age 65).

Japan’s powerful bureaucracies and interest groups have stymied agricultural and retail reforms. Much-needed energy reform is also still on the back burner.

In addition, Japan’s central bank is buying assets at an annual rate of more than $550 billion to stimulate the economy and fight deflation.

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So here is where we sit right now: As the Japanese yen has slid to 110 yen to one dollar — the lowest level in six years — imported goods and materials are getting more and more expensive.

The yen’s sharp slide is hampering consumer spending and weakening public backing for Abe’s economic program. In fact, consumer expectations about economic conditions a year ahead have fallen back into negative territory after brief optimism at the beginning of the Abe administration.

Japan’s stock market will only take off to the next level if Abe’s third arrow hits the bull’s-eye. And America needs a stronger Japan to boost global growth and security.

Until next time,

Carl Delfeld for Wealth Daily

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