In the past week, two important things happened in Japan. First of all, the Nikkei stock market index hit an all-time high; finally, eclipsing the previous record established 35 years ago. Following decades of underperformance, Japanese equities have left US stocks in the dust during the past two years. Meanwhile, the Bank of Japan (BOJ) began the process of monetary policy normalisation. By tightening policy for the first time in eight years, the BOJ became the last major central bank to exit the extraordinary period of negative interest rates. The BOJ also made important initial changes to its asset purchase program; aimed at capping the level of 10-year bond yields (JGBs).

One doesn’t have to be a cynic, however, to point out the Nikkei’s outperformance (assisted by the yen’s 30% depreciation) coincided with the US Federal Reserve’s decision to begin raising interest rates in March 2022. Indeed, the Chart above illustrates Japan’s post-Covid recovery has lagged far behind the USA and other competitors.

Has enough fundamentally changed in Japan to warrant further equity outperformance, especially as the Fed and ECB are poised to ease monetary conditions this Summer? To be sure, corporate profitability has improved, and accelerating wage growth suggests deflationary pressures have receded. And, while 2024 GDP should advance 1-1.5%, this tepid economic performance represents a deceleration from last year’s 1.9% gain. However, Japan’s economy still confronts formidable headwinds. Addressing the nation’s rising government debt burden, declining population, flagging productivity, and weak capital spending will limit Japan’s long-term GDP growth potential to 0.5% per year — not too dissimilar to the past 20 years.

Therefore, perhaps it’s fair to say, the hard part still lies ahead in Japan. Given these structural impediments, the BOJ will normalise monetary policy very cautiously during the next few years. While the Nikkei is no longer particularly cheap, the continuation of accommodative financial conditions should support equity prices. And, the undervalued JPY should depreciate further. Nevertheless, I would begin reducing overweight positions, and reallocating funds towards other Asian and European markets. Meanwhile, the potential repatriation of huge fixed-income investments held overseas by Japanese investors should limit adverse effects of the BOJ’s policy shift on domestic JGB yields. However, a fiscal crisis and a loss of confidence can’t be ruled out at some stage.

Government Debt: Elephant in the Room

Of course, the poor condition of Japan’s public finances is well known. Government debt is twice as high as other OECD nations; even making the USA appear fiscally responsible (Chart above). What is less appreciated is how unstable the situation is. During the pandemic, for example, Japan’s debt ratio jumped over 20% of GDP compared to 7% in other advanced economies (15% in the USA). And, debt as a percent of GDP will continue to rise until significant belt-tightening takes place.

What needs to happen? Simply to stabilise (not even to reduce) the debt ratio, Japan’s budget deficit must decline by roughly 4% of GDP over the medium term. However, Japan’s government confronts signficant demands for additional spending. In particular, health care costs (and pensions) will escalate as the population ages. Health care spending has already doubled during the past 20 years, but will increase another 5% of GDP by 2050 (Chart above). In addition, Japan’s net-zero energy transition will require substantial public sector investment. Therefore, the required fiscal adjustment may be up to 8% of GDP.

However, excluding social security, Japan’s government spending is lower than most OECD nations already (Chart above). Consequently, belt-tightening will likely require higher government receipts. Tax revenues as a percent of GDP have risen consistently in recent decades, and are now similar to the OECD average. In the future, however, Japan may require taxation near European levels eventually to balance the books.

To be sure, Japanese authourities will want to avoid past mistakes of tightening fiscal policy before the economic recovery is secure. Nevertheless, restrictive budgets will be an ongoing headwind during the next decade. The normalisation of BOJ policy, therefore, will proceed very cautiously.

Consumer Spending: Is Deflation Over?

To be bullish on Japan, one must be confident that deflation is over. And, can other sources of spending emerge as the government addresses the budget deficit? Declining nominal and real wages were key contributors to Japan’s deflationary era (Chart above). And, despite the recent rise in pay, inflation-adjusted compensation has continued to decline. Fortunately, this Spring’s Shunto pay round should produce 3-4% nominal wages increases.

Therefore, with inflation now declining, real incomes should finally rise in 2024. And, Japanese households still hold excess Covid-related savings. Thus, consumer spending should expand 1-2% this year. However, this outcome is far from secure, and should be closely monitored. Indeed, household spending has been stagnant during the past decade, and has contracted during the last three quarters of 2023. Over the medium term, moreover, consumers are likely to experience higher taxes, including VAT hikes.

Structural Headwinds: Labour Supply

Japan’s shrinking population will remain a headwind for consumer spending. In addition, contracting labour supply contributes to the nation’s tepid long-term potential GDP growth rate of 0.5%. Already, Japan’s dependency ratio (elderly as a percent of population) is the world’s highest, and may remain so in coming decades (Chart above).

While not much can be done about the low birth rate, policies can help boost labour supply. In particular, raising the mandatory retirement age — most people stop working at 60 (Chart above). Likewise, despite rising recently, female labour force participation could increase further, which will require additional government spending for child care, etc. Considerable social change may be required to fully capture women’s potential contribution to the workforce (Chart below).

Higher immigration, especially of high-skilled employees, could make an important contribution to labour supply. However, Japan remains at the bottom of the table on foreign worker inflows (Chart below).

Solving the Productivity Puzzle

As in other advanced economies, Japan has experienced a sharp slowdown in productivity growth in recent decades, which has contributed to its faltering GDP growth potential (Chart above). The performance since the Global Financial Crisis is especially worrisome. Moreover, Japan starts from a position where labour efficiency is far lower than in competing nations (Chart below).

Of course, an in-depth discussion of this issue is beyond the scope of this blog. However, Japan’s labour model featuring lifetime employment likely stifles innovation. As a result, perhaps, Japan lags far behind in the creation of the high-productivity, high-paying jobs of the future (next Chart).

Corporate Restructuring, Deleveraging, Investment

Japan’s current account surplus of 4% of GDP reflects the nation’s high level of savings. With the government running a budget deficit, the private sector accounts for the surplus thrift. However, the household savings rate has been declining for the past few decades (largely reflecting population aging and weak income growth). Therefore, high levels of corporate savings account for most of the nation’s excess savings (next Chart).

Typically, a corporate sector financial surplus might be considered favourably if it reflected strong profitability. Unfortunately, that’s not the explanation, despite a recent rebound in Japanese corporate profits. Rather, the surplus reflects a sharp decline in the investment rate since the bubble burst in 1990 (Chart below), which has contributed further to the deceleration in the nation’s long-term growth potential.

To be sure, Japan’s investment rate appears to be stabilising, and is higher than in other advanced economies. However, Japan’s low level of productivity suggests Japan’s returns on investment are low compared to other countries. Moreover, despite the high savings rate, Japanese corporate leverage is higher than other countries: 115% of GDP compared to 85% in other advanced economies. And, while firms in other countries reduced debt since the pandemic, Japan companies have boosted borrowings (next Chart). As interest rates rise, Japanese firms may choose to delever rather than boost capital spending.

Strategic Implications:

• Japan’s deflationary era appears over. The recent surge in prices will recede. I expect inflation to decline towards 1-1.5% by the end of 2024.
• Falling inflation and rising wages will boost consumer spending in 2024. GDP will continue to grow 1-1.5% this year.
• However, shrinking population, low productivity, and weak capital spending limit Japan’s long-term growth potential to around 0.5%. Fundamentally, not enough has changed to change this medium-term outlook.
• With the Fed and ECB cutting rates this summer, I would reallocate investments from Japan to Europe and other Emerging Markets.
• As BOJ policy will normalise cautiously, the deeply undervalued JPY will depreciate further (next Chart).
• Likewise, the potential large-scale repatriation of overseas fixed-income investments will limit the impact on JGB yields as the BOJ tightens financial conditions.