After a steady rise since November – sparked first by then-opposition leader Shinzo Abe’s campaign calls for bold monetary stimulus, and then fueled by Abe’s election as Prime Minister and the implementation of major easing measures in April – Japanese equity markets have turned choppy recently. A large selloff pushed the benchmark Nikkei 225 index down 20 percent in mid-June from a May 22 peak, and big swings in prices throughout the past month indicate that some investors are beginning to doubt the market’s staying power. But a July 1 report by Credit Suisse (“Japan: The Sun is Still Rising”) suggests Japan’s rally has legs, and will continue through the third quarter and beyond. In fact, Credit Suisse’s global equity strategy team believes the Nikkei will end the year at 15,500 – nearly 8 percent higher than it is now.
Some of investors’ skittish behavior stems from uncertainty about whether the Bank of Japan (BoJ) is inching away from a full-out war on deflation and negative growth. In June, for example, a BoJ board member suggested that easing should be limited to two years. Credit Suisse Chief Japan Economist Hiromichi Shirakawa pointed out earlier this month in a research note (“Credible Irresponsibility Needed?”) that some of Japan’s central bankers and government officials have also been stressing the need for fiscal restraint through budget cuts, which investors worry could derail monetary efforts to spur economic growth. Japan carries a budget deficit of 7.5 percent of GDP, and the International Monetary Fund said this spring that the country’s debt level is approaching 245 percent of the size of the economy. The concern is that the central bank’s massive purchases of Japanese sovereign bonds could push up yields if investors lose faith in Japan’s ability to service its debt, which would in turn increase the size of the debt even further, Shirakawa wrote. Government and BoJ officials have argued that the government would need to send a “credible message” about the country’s commitment to fiscal austerity to prevent those kinds of doubts from taking hold.
Still, Credit Suisse’s global equity strategy team believes the table is set for the BoJ to keep money flowing, further weakening the yen and feeding the rally. One reason policymakers will be tempted to keep the yen cheap is because inflation has continued to fall despite the stimulus to date. Shirakawa is forecasting inflation of only 0.6 percent in 2014, a figure well short of the BoJ’s target of 2 percent, meaning the central bank may need to drive the price of the yen down even further to meet its inflation goal. The Japanese have other reasons to try to weaken the yen, too. “(Japan’s) assets are denominated in foreign currency, while liabilities are yen-dominated,” the team wrote. “(Therefore Japan) is in the enviable position of being able to generate taxable wealth via currency weakness.”
The weakening yen has also boosted corporate earnings expectations, as a series of upward revisions to Japanese earnings estimates over the last three months shows. Credit Suisse also foresees positive sales growth for Japanese companies, noting that 2013 sales forecasts have already moved up by half a percentage point since Abe took office in December. Between rising profit expectations and Credit Suisse’s forecast of sales growth as much as a percentage point higher than the current consensus of 3 percent, Japanese stock prices appear due for another bump come earnings report season.
Of course, there are still investors who fear government policy will kill the rally. Besides the concerns that drove the recent market swings, there are longer-term worries, such as whether a hike in the consumption tax rate set to take effect in January 2014 will hurt economic output. But the Credit Suisse report argued that these fears are overblown. Shirakawa said the government will likely nix the consumption tax increase if the economy begins to falter, and the BoJ has shown that it can be proactive if it feels the economy is losing steam – the massive stimulus unleashed this spring went beyond buying government bonds to make the central bank a buyer of exchange-traded funds and real estate investment trusts. The BoJ could easily increase its purchases of ETFs and REITs to keep stoking a recovery, and Shirakawa said the central bank may do just that in October. Finally, the BoJ has also implemented a popular loan program that allows banks to borrow cheaply from the central bank in return for good quality collateral, a program that should encourage lending.
But the Japanese market’s most powerful secret weapon may be the Japanese people themselves. Domestic investors have been net sellers of equities since the beginning of the run-up in the Japanese stock market, choosing to hold cash rather than buying equities or simply spending the money. If the BoJ meets its inflation target, then Japanese investors may be encouraged to finally start opening their wallets. “It is logical that when there is inflation threat, domestic investors seek to move out of cash into property, overseas assets, equities or even purchase real assets. Any of these allocations would help equities,” the report said. In other words, if Japan can keep the yen down and inflation up, its rally may have more room to run.