• We maintain a positive outlook on Japan and expect more tailwinds (rising corporate profits, tax cuts, Olympics-related demand, rising immigration) to continue.
• We believe that Japan's GDP is on a sustained growth track supported by structural reforms coupled with the Bank of Japan's (BoJ) accommodative monetary policy.
• We expect a normalisation of price setting strategy to help buoy both revenues and profits, while tax cuts should help to maintain Japanese business confidence, which is already close to the highest levels since the late 1980s.

We wrote about our positive outlook on Japan¹ from the viewpoint of corporate governance reform, labour market reform and relative competitiveness of Japanese companies. Our constructive view remains unchanged, and for 2018 we expect more tailwinds (rising corporate profits, tax cuts, Olympicsrelated demand, rising immigration, etc.) than headwinds (geopolitical risk, China slowdown, etc.).

SUSTAINED GDP GROWTH

Japan's GDP has expanded for seven consecutive quarters, which is the best run in sixteen years. As shown in the chart, Japan's nominal GDP is making a new high of ¥549 trillion, the highest level in 20 years. In 2015, the Japanese government set a target to increase nominal GDP by 20% to ¥600 trillion, which is 8.5% shy of its goal, as of Q3 2017. We think that GDP is on a sustained growth track supported by both structural reforms such as labour and tax reforms, coupled with the Bank of Japan's (BoJ) accommodative monetary policy.

Figure 1: Japan's GDP breaking out on the upside

Source: Bloomberg, Economic and Social Research Institute Japan.

DEFLATION EXIT - READY OR ALREADY?

It is true that inflation hasn't risen to the 25% level which the BoJ has long targeted, but our on-theground research suggests that the Japanese economy is no longer deflationary, with food, taxi fares, office rent, delivery service and restaurants all seeing rising prices. Japan's CPI has increased steadily over the past year, reaching +0.9% YoY in November 2017. In determining whether the economy has made an exit from deflation, the Japanese government has focused on four main indicators as shown in the four graphs below: 1) CPI, 2) GDP deflator, 3) unit labour costs, and 4) the output gap. All of these indicators are about to move into positive territory at the same time, the precondition for the official determination of the end of deflation. Until there are sustained positive readings from the four indicators at the same time for a few quarters, the accommodative monetary policy is expected to continue. Given the changing inflationary environment, Japanese companies have started to review their strategies for selling products and services with proper pricing² and not to cut prices simply to gain market share. This 'normal' pricing behaviour hasn't been seen for quite a long time due to the entrenched deflationary mindset. This normalisation of price setting strategy should help buoy both revenues and profits, and further improve the margins of Japanese companies.

Attention is now being paid to wage inflation. We have seen some wage hikes in the lower income segment, but overall wage growth still looks anaemic. The word on Japan's Main Street is that companies have excessive profits but retain it as an internal reserve rather than pay out to employees. Investors believe that companies don't pay out excess cash to shareholders, even though corporate Japan keeps more than ¥200 trillion of cash (US$1.8 trillion) on the balance sheet, with negative interest on a real basis. This is about to change.

As we will discuss later, Japan's labour market is at its tightest historically, so that wage pressures should impact wage growth sooner rather than later. Japanese Prime Minister (PM) Shinzō Abe has promised to reward companies that raise wages more than 3%. Taking into account PM Abe's indicated expectations of a 3% wage hike and public opinion, Keidanren (Japan Business Federation) will present specific policies for wages, and encourage debate between management and labour within individual companies. Decisions on wage increases will be left to each company, but Keidanren will ask them to adopt a forward-looking approach to wage increases for the sake of the virtuous economic cycle and the reinvigoration of consumer activity.

Figure 2: Headline Consumer Pride Index (YoY, %)	Figure 3: GDP deflator (YoY, %)
Note: Adjusted by Morgan Stanley Research for consumption tax effects. Source: Ministry of Internal Affairs and Communications, Morgan Stanley Research.	Note: Adjusted by Morgan Stanley Research for consumption tax effects. Source: Cabinet Office, Morgan Stanley Research.
Figure 4: Unit labour costs (YoY, %, Our estimate)	Figure 5: Output gap (%, Cabinet Office estimate)
Source: Cabinet Office, Morgan Stanley Research.	Source: Cabinet Office, Morgan Stanley Research.

LABOUR FORCE GROWTH TO BOOST GDP

Japan is enjoying its longest run of labour force growth since the late 1990s, as the labour market continues to tighten. The job-to-applicant ratio suggests that there are 1.6 jobs available per job seeker in Japan - the tightest labour market we have ever seen. A key Abenomics success is getting more women into the workforce to lift household income. The government's various efforts are starting to bear fruit - some 1.5 million Japanese women have been added to the workforce over the last four years, raising the female labour participation rate (15-64) to 68%, up 8 percentage points in the last 15 years, catching up with the US (according to OECD data). Also, the number of foreign workers has been rising, hitting the one million mark in 2016 for the first time ever. What's interesting to us is the consistent increase in the number of foreign residents. It is true that PM Abe claims that the Japanese government is against any radical immigration policies, and it remains a controversial agenda in the homogeneous Japanese society. However, stealth immigration seems to be underway, driven by the need to bolster the labour force. Immigrants as a percentage of total population is still much lower than in other countries, but its sustained uptrend reminds us of our history lessons - the 'Convention of Kanagawa' in 1854 (a treaty between Japan and the US) forced Japan to put an end to its national isolation that had existed since 1616.

Figure 6: Jobs-to-Applicant ratio at its highest in two decades

Source: Ministry of Health, Labour and Welfare, Japan.

Figure 7: Labour force YoY growth the longest run since 90s

Source: Ministry of Internal Affairs and Communications.

Figure 8: OECD female labour force participation rate (15-64)

Source: OECD.

Figure 9: Japan immigration rising even higher to 2.47m in 2017, or 1.96% of population

Source: Cornerstone Macro.

TAX CUTS TO BOOST GDP AND CORPORATE PROFITS

Since the Abe administration came into office, the government has been lowering the effective corporate tax rate to make Japan more attractive for businesses. The overall effective corporate tax rate in Japan has fallen from 37% in 2012 to 29.74% effective April 2018. Additionally, Japan approved new tax measures to cut corporate taxes further to 25% for companies that raise wages by 3%, and to as low as 20% for those that invest in new technologies. The Japanese government is also examining the idea of slashing fixed-asset taxes to help small- and mid-size companies boost productivity. We believe that these conditional tax cuts should be positive for the economy and the corporate sector, as they will contribute to improving competitiveness and productivity. We think that these tax cuts should help to maintain Japanese business confidence for the time being, which is already close to the highest levels since the late 1980s.

Figure 10: Corporate tax to drop below 30%

Source: Cornerstone Macro.

TO TWEAK THE YIELD CURVE CONTROL POLICY BUT NO MONETARY TIGHTENING

Given the positive macro backdrop, some people are starting to think about probability of BoJ's policy shift. Our view is that BoJ is likely to shift the target in its YCC policy (Yield Curve Control), allowing the Japanese Bovernment Bond (JGB) yield curve to somewhat steepen if growth continues to be strong and inflation is sustained.

When BoJ Governor Haruhiko Kuroda made a speech in Switzerland last November, he mentioned that most corporate and household financing is based on short- to medium-term interest rates, but longerterm interest rates are likely to be more relevant for society's financial infrastructure functions such as insurance and pensions. He explicitly mentioned the 'reversal rate'. Academic research³ suggests that there may be a point where further interest rate declines are likely to do more harm than good to the economy. Nobody knows where that level is, but the fact that he referred to it suggests that BOJ is perhaps thinking that low shorter-term rates are more effective in stimulating the economy than low longer-term rates. In fact, after years of massive asset purchases, BoJ's data indicated total assets on its balance sheet slightly shrank from the end of November to December 2017, the first monthto- month decline since the initiation of QQE (Quantitative Qualitative Easing) as a part of Abenomics. This move would help the JGB yield curve steepen, which would benefit Japanese banks, insurance companies and pension funds.

The probability of tweaking the YCC policy is rising. We should bear in mind that shifting the target and letting the long end of the curve rise would not be a tightening move. Even though Japan appears to have turned the corner on deflation, we believe that BoJ will persist with powerful monetary easing to nurture positive inflation developments. Continuing accommodative monetary policy should be friendly to the equity market, and should help Japanese business confidence, which is close to the highest levels since the late 1980s, remain elevated.

As we discussed in the previous paper,⁴ corporate governance reforms are beginning to change Japanese companies' mindsets into becoming more shareholder friendly - increasing returns on equity and returning excess cash to shareholders. Better corporate governance in Japan is still a work in progress, but companies are clearly making good progress.

Japanese equities are trading at reasonable valuations - approximately 15x forward earnings and 1.4x book value (vs. 18x, 3x for the S&P 500 in the US). Given continuing corporate earnings growth, supported by a solid macro environment and innovative activities by Japanese companies, we continue to expect reasonable equity returns to be delivered over the next few years.

¹ http://www.columbiathreadneedle.co.uk/en/insights/2018/01/japan-three-reasons-for-a-positive-outlook/
² https://asia.nikkei.com/Business/Companies/Yamato-gets-Amazon-to-pay-40-more-for-shipping-in-Japan
  https://www.bloomberg.com/news/articles/2017-06-12/why-it-took-27-years-to-hike-prices-at-japan-parcel-giant-yamato
³ https://scholar.princeton.edu/markus/publications/reversal-interest-rate-effective-lower-bound-monetary-policy
⁴ http://www.columbiathreadneedle.co.uk/en/insights/2018/01/japan-three-reasons-for-a-positive-outlook/

Download PDF