Nearly halfway through 2017, most eyes are fixated on the West -- the Trump administration has hogged headlines globally, with elections in Europe filling any spare space. To the extent the world has looked at Asia, it has focused on South Korea's political scandal, which culminated in their president's impeachment and removal from office, and China's economy and banks.

Meanwhile, one of the globe's biggest economies has slipped under the radar: Japan. The Land of the Rising Sun has struggled economically throughout the broader expansion, and many pundits are growing dour about Japan's economy and stocks -- particularly because of allegedly tense trade relations. On the rare occasion Japan does rate coverage, it is largely from this pessimistic viewpoint. While we agree Japan's economy likely continues to struggle, sentiment appears to be catching up with this weak reality. Stocks move most on the gap between sentiment and reality, and these lowered expectations increase the risk Japanese data and/or reform efforts positively surprise.

A lackluster economy isn't a new development: See Japan's Lost Decade(s) for more. Since the current global expansion began, Japan suffered consecutive GDP dips -- fitting one technical definition of recession -- in 2011, 2012 and 2014. Japan's official business-cycle dating committee has declined to name them recessions officially, but that doesn't change the fact the economy took multiple downturns.

One-off events like the Great Tohoku Earthquake of 2011 played a role, but weak domestic demand has been the persistent issue. In late 2012, present Prime Minister Shinzo Abe took office and promised to revitalize the economy via his three-part "Abenomics" program: extraordinary monetary easing, fiscal stimulus and economic and structural reform. The first targeted long-running deflation, the second would kick-start growth and the third aimed to liberalize the economy in the longer term.

Abenomics' potential excited foreign observers and raised expectations -- which also set up disappointment if the program fell short. Hence, Japanese stocks outperformed substantially right after Abe was elected. But this hasn't lasted: Japan has overall underperformed developed-world stocks since Abe took office December 26, 2012.[i]

Today, sentiment is more aligned with reality. While Abe delivered monetary easing and fiscal stimulus, folks now recognize these measures alone haven't spurred growth. The Abe administration passed some reforms (e.g., corporate governance and labor), but they haven't been as deep and impactful as hoped. Despite the hype, reinvigorated domestic demand remains absent, and trade has been the primary growth driver. Thus, given recent talk of protectionist trade policies -- specifically from leaders of major trading partners -- some observers fear the country's already tepid growth will be snuffed out.

However, the data don't paint that dire a picture. Japan has enjoyed global trade's recent rebound. May export values were up 14.9% year-to-year while import values rose 17.8%.[ii] While this sounds good, values figures aren't all-telling due to currency impact -- trade volumes say more. On this front, May exports (7.5% year-to-year) and imports (5.4% year-to-year) have been on an uptrend.[iii] If the global trade rebound continues and protectionist talk doesn't amount to action, there is the potential for upside surprise here.

Other data show moderate improvement, too. In May, Japan's services (53.0) and manufacturing (53.1) PMIs, or Purchasing Managers' Indexes, were above 50 -- indicating expansion for the seventh straight month -- a sign more firms are growing than not.[iv] Meanwhile, April retail sales picked up from March's 2.1% year-to-year to 3.2%. However, reality still isn't rosy.

Consumption is still weak, as consumer spending slipped -1.4% year-to-year in April -- its 14th straight negative reading.[v] Though business investment rose 2.5% annualized in Q1, it has been volatile for years and has yet to show a sustained uptrend. Overall, the largely lackluster expectations toward Japan seem appropriate. The development to watch is whether the data meaningfully pick up or if expectations fall lower from here -- potentially widening the gap between perception and reality.

As for politics, Abe has seemingly eased his effort to revise Article 9 -- the anti-war clause -- of Japan's Constitution. Abe has pursued this lifelong ambition since his tenure's start. However, change requires significant political capital, and Abe's efforts have met stiff resistance, causing him to moderate considerably.

Whereas pundits wondered before if he would scrap Article 9 altogether, today Abe is focused on a Special Defense Forces provision -- basically keeping everything else. This theoretically frees up political capital to deploy elsewhere, and if Abe does end up using it toward reforms -- even incremental ones -- that could result in a positive surprise.

That said, this status quo isn't overall positive. Japan's long-running issues are likely to keep running: a stagnant economy restrained by entrenched special interests, a byzantine labor code and an overall protectionist trade policy, among other issues. Growth will likely remain tepid, weighed down by weak domestic demand.

But stocks move most on the gap between sentiment and reality. With sentiment plunging and global trade picking up, there is an increasing risk of Japan positively surprising with reform and/or economically. If sentiment declines further, this risk becomes more acute.

[i] Source: FactSet, as of 6/19/2017. MSCI Japan and MSCI World Ex Japan indexes with net dividends, 12/15/2012 - 6/16/2017.

[ii] Source: FactSet, as of 6/19/2017.

[iii] Source: Japan Customs Office, as of 6/19/2017.

[iv] Source: IHS Markit, as of 6/19/2017.

[v] Source: Statistics Japan, as of 6/19/2017.

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