Investors Not Impressed with Abe’s “Third Arrow”

The Japanese equity market suffered another 3+% drop on June 5th and slipped a further 0.8% on June 6th as investors showed their dissatisfaction with a speech by Prime Minister Shinzo Abe outlining the “third arrow” of his plan to revive the economy. The first two “arrows” are a large supplemental budget and a massive program of quantitative easing by the Bank of Japan (BOJ). While the first two arrows should stimulate economic activity, achieving a sustainable higher-growth path and winning the battle against deflation will require a broad program of market-friendly reforms.

Investors were looking for more specific information on planned reforms than Abe was prepared to give. His reluctance to give more details at this time, in particular, in the area of labor market reforms probably was due to the upper house elections his party faces in July. Should he get a majority in that house, he will be in a stronger position to take on the vested interests that oppose reforms. Abe indicated that the growth program will not begin for months. Yet the time has apparently run out for the market to be satisfied by general promises.

The broad outline for reforms presented in various speeches and statements by Abe is indeed impressive. It includes joining talks on the Trans-Pacific Partnership Trade Bloc, doubling inward foreign direct investment by 2020, reforming the agricultural sector, stimulating domestic business investment through tax incentives, deregulating certain sectors of the economy (health, infrastructure, energy), increasing the participation of women in the work force by creating 250,000 daycare places for children, and splitting electric utilities generation and transmission and fully liberalizing the sector. In yesterday’s speech he announced an ambitious target of 3% annual gains in gross national income per capita. Another ambitious target is to increase investment in the electricity industry to about 30 trillion yen ($299 billion) in 10 years.

One announced measure is of particular importance to the equity market: the Government Pension Investment Fund (GPIF), other public pension funds and other institutional investors are to be urged to lift their automatic curbs on equity holdings. This could have a significant effect. As pointed out recently in the Financial Times, total assets of the GPIF are about the size of the South Korean economy. Institutional investors will also be urged to exercise their voting rights rather than remain passive investors. This would be a positive step in strengthening corporate governance in Japan.

In our May 28th note on Japan we concluded that the correction in the Japanese equity market presented an attractive entry point. We also recognized that “the equity market correction may well continue a bit further.” That understates the further correction experienced since May 28th. We anticipated incorrectly that Abe’s “third arrow” would receive a positive reaction. There will still be opportunities to assure the market that the reform promises are backed by substantive action plans. We note that the full text of Abe’s “national growth strategy” is to be released next week after Abe’s cabinet determines the details. That may well elicit a more positive market response.

In the meantime the BOJ will continue with its massive quantitative easing program. The monetary authorities are unlikely to consider tapering off this program until they see clear evidence that the economy has definitively emerged from deflation. As its purchases of Japanese government bonds increasingly dominate that market and Japanese investors turn to other markets, it is highly likely that the yen will resume its weakening trend. We are maintaining our view that the Japanese equity market is likely to outperform global markets in the coming months and probably for an extended period.

We are continuing to use the WisdomTree Japan Hedged Equity ETF, DXJ, in our International and Multi Asset Class Portfolios. The complete hedging of the exchange-rate risk is attractive in a period of anticipated weakening of the yen versus the US dollar. We also like the way this ETF selects and weights its holdings based on dividends and excludes companies that derive 80% or more of their revenues domestically. As a result, DXJ overweights industrials, information technology, and health care and underweights financials, telecoms, and utilities as compared with the MSCI capital-weighted index for Japan and the ETFs that track that index. Thus far this year, including the correction, DXJ has performed significantly better, +20.31%, than the unhedged Japan ETFs such as the widely held iShares MSCI Japan ETF, EWJ, +8.72%.

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