The Japanese stock market is rallying, and there are still good gains to be made. Thanks to the bold economic policies of Japanese Prime Minister Shinzo Abe, private companies and their shareholders can expect to reap the rewards of boosted revenues.
Wary investors may feel like they've been here before when it comes to Japan. The stock market has shown promise in the past, only for any gains to be wiped out months later. The troubled economy has held the stock market back.
Prolonged periods of deflation and a rampant currency for the past 20 years has knocked consumer confidence and made the country unattractive to foreign investors. On top of this, Japan is struggling with a rapidly aging population, which means fewer people paying income tax and a rising number of people burdening the state.
But then in 2012 Abe was elected as Prime Minister. He had previously held the post in 2006, but this time around he has the backing of the people, the private sector and -- perhaps most importantly -- the Bank of Japan. He came to power on the promise of radical economic reform which would instil sustainable inflation and economic growth -- a movement that has been coined "Abenomics" and billed by Japanophiles as the nation's salvation.
What is Abenomics?
Abenomics has been described as a three-arrow system. The first arrow is quantitative and qualitative easing (QQE) -- basically pumping the monetary system full of cash to kick start economic growth. The scale of this easing has dwarfed that of the United States and Europe and will continue to drive down the currency, making doing business with Japan cheaper and more attractive to foreign businesses.
The second arrow involves changes to the tax system to help generate more income for the public purse, including increasing the sales tax from 5% to 8% last April.
The third arrow is more complex that the other two. It aims to restore the confidence of companies and the public in the Japanese economy, abolishing deflation once and for all. This stage has been called the Japan Revitalisation Strategy, and aims to help businesses help themselves and increase the profitability of Japan. Abe called a snap election in December 2014 which resulted in his re-election, buying him time to properly execute the third arrow of economic reforms.
In recent months, the government of Japan has met with the six largest employers in the country -- which include Toyota, Nissan and Panasonic -- and together they have agreed to raise the base wages of their employees starting in April. These global companies have seen the benefits of Abenomics on their balance sheets; the weaker yen has boosted industrial companies and exporters, and it is time to pass on those benefits to employees, which will in turn help boost inflation.
As well as base wages being raised, these companies are adopting a new remuneration policy. Currently, Japanese employees' wages are based on how long they have worked for a company; the older you are, the more you are paid. The largest companies in Japan are now adopting performance-based pay, encouraging the best and brightest to stay on their payroll -- essential in a country where the pool of employable young people is shrinking.
These large companies are also increasing what they pay their suppliers, meaning that small and mid-sized companies, which employ the bulk of the Japanese workers, will be able to increase what they pay their staff too. More yen in the pockets of these workers will translate to greater spending, boosting inflation and the economy.
What can go wrong for Japan?
Abe may potentially hold the keys to Japan's success, but even those who believe in his transformative abilities are not flippant about the challenges head.
"In the 20 years to November 2012 when Abe was elected, the Topix Japanese stock market index had experienced no sustained rally for 20 years; in fact it was at its lowest point over that period," said economist James Dowey of Neptune Investment Management.
"Since then the markets have rallied 115%; it is on a sugar high thanks to QE and a depressed yen. But this is a [band-aid] not the cure. There are deep cultural challenges embedded in the Japanese economy which are difficult to change and could ultimately lead Abenomics to fail."
One of these challenges is that more than 50% of household assets are held in cash in Japan. This that makes sense in a deflationary environment, but with the Bank of Japan flooding the system with cash and wages, rising inflation can't be too far behind.
Dowey was speaking in Tokyo last week as part of a Neptune research trip analysing the real effects of Abenomics on Japan's economic and investment prospects. He believes that if the powers that be can create a prolonged period of inflation, Japanese consumers will do what is required to turn the country's prospects around, permanently.
"Abenomics had made progress. Before QQE, inflation was -1%. It then rose to positive inflation but following the sales tax hike and the fall in the oil price inflation fell to 0%. To achieve the Bank of Japan's aim of 2% by 2016 there will have to be significantly more QQE," he said.
Dowey predicts the Bank of Japan will end up doing more QQE than necessary, and more than it has initially stated, just to secure consumer confidence. Once inflation settles in, keeping their savings in cash will no longer seem an attractive option for the Japanese and they will turn to the stock market.
This demand from retail investors should push the Japanese stock market higher, as should the increased demand for domestic equities in the revised pension portfolios. Before Abenomics, only 15% of Japan's pension fund was invested in equities; now it is on course to hit 50%. This will be made up of 25% domestic stocks with global revenues and 25% foreign stocks -- hedging the future income of the aging economy against the weak yen of today.
