Checking In on Japan

With all the high-profile events at home and in Europe, Japan may be easy to overlook. But global investors shouldn’t ignore the Land of the Rising Sun—a sizeable chunk of developed markets and the world’s third-largest economy. Take a gander at how Japanese inflation, monetary policy and GDP are faring across the Pacific.

Wages Lag Inflation in Japan, Too

Japan’s annual spring “shunto” wage negotiations between labor unions and management show rising labor costs are an aftereffect of inflation, not necessarily a prelude to an escalating wage-price spiral. Last Thursday, UA Zensen, the country’s largest union organization representing 240,000 workers, secured a 5.28% wage hike to keep pace with 4.4% y/y inflation—following similar deals major automakers made with their workers.^[i] This year’s hike followed last year’s 2.2% raise, which was the first increase in four years.^[ii] For some broader context, consider: Before this year, annual raises didn’t exceed 3% since 1997—with no base-pay hikes until 2013. Consumer prices were deflationary much of this time, so meager nominal wage gains were enough to pump real wages.

In our view, this shows how past inflation impacts wages, as it took the recent pickup in inflation to drive larger increases. But past prices don’t predict. Companies’ paying workers more doesn’t suddenly mean they can (or will) then turn around and raise their prices an equivalent amount. That depends on supply and demand in their chosen markets. Wages are incidental to this. Economic conditions could still force firms to cut prices to clear inventory, for example, no matter how much they raise wages.

Whether in Japan or elsewhere, the data say wages don’t drive inflation—they trail it. No surprise then that long-term Japanese market-based inflation expectations haven’t budged above 1% despite supposed wage pressures building.^[iii]

New Governor, New Monetary Policy?

After receiving legislators’ blessing last week, Kazuo Ueda will officially succeed long-serving Bank of Japan (BoJ) Governor Haruhiko Kuroda on April 8, as speculation swirls over the BoJ’s monetary policy direction—and what that means for markets. Alongside Ueda, Parliament also confirmed two new BoJ members, which highlights the difficulty in predicting how any rotating cast of characters—all with their own unique opinions and biases—will vote. Instead, we think it best to assess decisions when they come. No need to agonize over potential changes to monetary policy beforehand, especially since: 1) the economic effects tend to hit at a 12 to 18 month lag, and 2) the market impact isn’t predetermined.

That said, the BoJ’s quantitative easing (QE), negative interest rate policy (NIRP) and yield curve control (YCC) are worth monitoring. All have been counterproductive to growth, in our view—yet most still see them as accommodative. The BoJ was the first central bank to implement QE in 2001, buying Japanese government bonds (JGBs) to suppress long-term rates. QE expanded after Kuroda took the helm in 2013 to include corporate bonds and even stocks. But QE flattens the yield curve—a proxy for banks loans’ profit margins, the difference between their short-term funding costs and longer-term loans’ interest income. That has reduced Japanese banks’ incentive to lend, not spurred it.

As we have written before about other central banks’ NIRP, the theory they induce more lending hasn’t worked in practice. NIRP is effectively a tax on banks’ reserves, theoretically penalizing idle funds held at central banks unless they back new loans. But the BoJ’s early-2016 NIRP squashed long-term interest rates more, further flattening the yield curve.^[iv] With lending even less profitable, loan growth stagnated.^[v]

Late 2016’s YCC was the BoJ’s attempt to remedy this. It targeted a 0% 10-year JGB yield, which was higher than where yields were trading at the time, prompting the BoJ to taper QE and let long rates rise. But over the last year, as other major central banks ditched their QE programs and developed market yields outside Japan rose with inflation, near-zero JGB yields increasingly became an outlier—and untenable. The BoJ has given some ground, widening the YCC band it defends to half a point in late 2022, after which 10-year JGB yields immediately shot up to 0.5%.^[vi] But even with this, YCC continues pulling long rates down instead of letting them rise.

We found it somewhat encouraging Ueda acknowledged these policies’ side effects in his confirmation hearing, but that doesn’t predict what the BoJ will do. However, wider recognition of their pitfalls opens the door to potential remedies. If and when they develop, investors are better off being aware of them.

How Is Japan’s Economy Muddling Through It All?

Last Thursday, the Cabinet Office revised its Q4 Japanese GDP estimate down to 0.1% annualized growth (rounding to flat on a quarter-over-quarter basis) from its 0.6% initial estimate—which follows Q3’s -1.1% contraction.^[vii] The downgrade came mainly from household consumption’s revision to 1.3% annualized growth, down from its 2.0% preliminary reading. Business investment fell -2.0% annualized, easing modestly from the previous estimate’s -2.1%, while trade’s positive contribution largely offset it, as exports notched their fifth straight quarterly gain. Meanwhile, residential investment was revised up to flat from a -0.5% annualized decline. Private domestic demand components—combining residential investment, capital expenditures and consumer spending—fell to -2.3% annualized growth from the -1.5% first estimated.

So, like most of the developed world (eurozone’s Q4 GDP growth was also revised lower last week), Japan’s economy is mixed under the hood. But while domestic headwinds continue to weigh, they seem widely known at this point. With external demand appearing to be a more consistent growth engine to us, having exposure to multinationals with greater ties to the world economy makes sense for a globally oriented portfolio. More broadly, with Q1 soon coming to a close, Q4 data are far in the rearview for forward-looking stocks, and more recent data suggest improvement.

Japan may not stand out in today’s news cycle, and returns have long been lackluster. But we don’t think it wise to look past one of the world’s major economies, as there are opportunities for global investors with a selective approach.