A New Turn for Japan’s Old Revolving Door

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Japan’s political fundraising scandal claimed another victim this weekend: the ruling Liberal Democratic Party’s (LDP’s) parliamentary majority. Yes, in the snap election new Prime Minister Shigeru Ishiba called to secure a public mandate, the LDP lost a whopping 56 seats, leaving it and coalition partner Komeito with just 215 of the lower house’s 465 seats, 18 short of a majority. The LDP still holds a plurality, but the opposition took 250 seats, including the Constitutional Democratic Party of Japan’s (CDPJ’s) 148. Headlines trumpeted that Japanese stocks’ political fundamentals changed overnight, but we think the results just bring long-running weakness more into public view.

Japanese stocks actually had a pretty good Monday, rising 1.5% in local currency.^[i] Most headlines dismissed this, calling it a knee-jerk hope that a hung parliament would inspire the Bank of Japan (BoJ) to halt its rate hike campaign. When this sugar high wears off, they warned, political instability will present new headwinds.

We see this differently. For one, political instability isn’t new in Japan. It has been consistent since the late Shinzo Abe stepped down in September 2020. Yoshihide Suga, who replaced him, lasted a little over a year. His replacement, Fumio Kishida, lasted less than two years. If Ishiba were to lose the job now, as many suspect he will regardless of whether the LDP is able to form a government, it wouldn’t be the return of the old revolving door that reigned before Abe. It would be the four-year-old door’s fourth turn. We don’t disagree that this is a headwind, but it isn’t new.

But we don’t think looking at this in terms of stability versus instability is necessarily the best framework. After all, gridlock—the likely outcome of any multiparty coalition, regardless of which party heads it—brings a lot of stability. When legislation can’t pass, policies don’t change, and the rules are stable.

In most of the developed world, we would generally view this as positive for stocks. An active government raises the risk of new laws creating winners and losers, which would increase uncertainty and potentially weigh on stocks. Exhibit A, right now, is the uncertainty hanging over UK stocks ahead of the new government’s fiscal policy overhaul, due later this week. But Japan is an exception, the rare place where gridlock is less beneficial because it means governments can’t pass more of the reforms needed to unlock domestic demand and earnings growth.

Reform prospects are a consistent driver for Japanese stock returns. Don’t get us wrong, Japan has a lot going for it. Its human capital and technological know-how are big assets, as is its local expertise in industrial machinery design and manufacturing. But there are also structural headwinds that prevent companies from fulfilling their potential. Complicated ownership structures whereby conglomerates own stakes in one another to entrench power is one. The lifetime employment culture is another. The proliferation of “zombie companies” that earn just enough to service debt and stay in business is a third. All, to varying degrees, are headwinds to productivity and innovation in the long run.

So when Japan gets a government that has the desire and political capital to achieve reform, it tends to be a strong tailwind for Japanese markets. Hence, there were some very good years for Japanese stocks under Abe and his reformist predecessor, Junichiro Koizumi. But when the likelihood of reform is much lower than investors hope, then it can weigh on stocks. This also happened under Abe, at times, as investors got overly optimistic based on his rhetoric and didn’t pay sufficient heed to the entrenched opposition within the LDP.

Reform prospects have been pretty bleak since Abe stood down. The prime ministers since have either back-burnered reform or not had the political capital to push it through. Kishida, for instance, spent most of his second year in power managing the fundraising scandal’s fallout. Of the main candidates vying to replace him in last month’s LDP leadership contest, Ishiba represented the least continuity with Abe’s reform agenda. He actually broke with several of Abe’s flagship policies early in the campaign before U-turning as the contest wore on. When he took power, expectations for reform were already pretty low.

So the election doesn’t seem like a sea change on this front. Rather, we think it just makes the low likelihood of reform more visible.

In the short term, it also raises uncertainty—a headwind. The world had pretty much penciled in an LDP cakewalk. Instead, we have a scenario where, to stay in power, the LDP will have to corral 18 more seats. Leaders will probably reach out to the Japan Innovation Party (38 seats) or Democratic Party for the People (28 seats), both of which have some ideological overlap with the LDP. But given voters ostensibly flocked to these parties to repudiate the LDP after the scandal, the smaller parties may deem it politically unwise to join forces with the target of their voters’ frustrations. However, it will also be difficult for the CDPJ to form a majority, given the oppositional parties’ competing priorities and ideologies. When its predecessor party formed a disparate coalition, in 1993, it lasted less than a year.

Most observers expect the LDP to push for a minority government and seek smaller parties’ support for bills on a case-by-case basis rather than form a formal, broader coalition. Perhaps that will work. Or perhaps CDPJ leader (and former prime minister) Yoshihiko Noda will succeed in his push for a change in government, heading either a minority administration or loose coalition. Either way, with parliament required to reconvene within 30 days to hold the vote for prime minister, clarity will come.

So investors are in wait-and-see mode in the short term. Even as that headwind fades, longer-term reform headwinds will probably persist, which likely keeps Japanese stocks from the top of the global leaderboard.