Japanese equities have had a roller-coaster ride to nowhere over the past year. The Nikkei 225 has eked out a 0.55 percent return. But at one point in the fourth quarter of 2018 it was firmly in bear market territory. Even the bounce back in 2019 has still seen Japanese equities underperform the United States, U.K. and Pacific Rim excluding Japan.
Concern over trade wars, the dominant narrative in the fourth quarter of 2018, has begun to feed through to economic data. The Business Conditions Coincident Indicator, published by the Cabinet Office, has fallen for four consecutive months. The Leading Indicator also points to continuing deterioration.
Bad News, Good News
The Bank of Japan's (BoJ) favorite economic indicator, the Tankan index of large manufacturers, fell from +19 to +12 when reported on April 1, the worst reading in two years and below expectations in a poll of economists by Reuters (+14). The broad Tankan index, conducted directly by the BoJ, fell from +16 to +12.
However, this bad economic news may prove good news for the stock market. BoJ governor Haruhiko Kuroda surprised markets with dovish comments in mid-February, though he has focused on yen strength and its potential impact on inflation rather than the stock market. The BoJ has limited scope to loosen monetary policy. Rates are at the zero bound and as a percentage of GDP it already has the most bloated central bank balance sheet anywhere in the world.
The BoJ has taken unconventional monetary policy into equity markets. In 2018 it bought ¥6 trillion of ETFs (exchange-traded funds) and it already owns close to 80 percent of all Japanese ETF assets. It could buy more, this still only represents around 5 percent of Japanese equity market capitalization, but the buying program is already facing criticism. Direct stock buying would be seen as an intervention too far.
The Formula for a Nikkei Rally
Further monetary stimulus is possible, but fiscal intervention is more likely. There were local elections in Japan in April and Upper House elections are set for July. In the previous two downturns to the leading indicator and Tankan in 2014 and 2016, which also coincided with national elections between five and seven months ahead, prime minister Shinzo Abe's government announced a delay in raising the consumption tax. This is set to rise from 8 percent to 10 percent in October.
This proved particularly effective in 2014, when the Nikkei rallied and yen weakened. The tipping point was likely external factors. The U.S. economy was strengthening and dragging global growth out of the doldrums. A catalyst for stocks this time could be China.
China a Catalyst for Growth?
On April 1 China's CSI 300 index rose 2.6 percent to its highest level since March 2018 after the official purchasing managers' index returned to growth after three months indicating contraction. China's growth slowdown may not be as bad as has been feared and its equity market enjoyed the best quarter in four years. Japan may be due for a catch-up rally.
There may be another support for Japanese stocks: better corporate governance. Japan's annual general shareholders' meetings season does not begin until June, but activism is already in full cry. A New York-based hedge fund has asked fellow shareholders in Toshiba to replace most of the board with independent directors.
It has likely been encouraged by the success of another U.S. manager that gained a seat on the board of Olympus in January.
Tangible Support for Equities
Waiting for bottom-up corporate governance reform in Japan to release shareholder value has been a bit like trying to find a black cat in a dark room that is not there. The current flurry of activity may be another false dawn. But a top-down review by the Tokyo Stock Exchange (TSE) of its "first section", the Topix, may provide more tangible support for equities.
The yen has always been regarded by global investors as a safe-haven. Having lagged other developed and Asian markets in Q1, policy, politics and a reviving China make Japanese equities look robust in Q2.
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