In the past twelve months, Japan has been responsible for some market volatility, something we are not accustomed to. A sign of this has been the recent sharp bond sell-off, which drove yields to record levels and attracted media attention. The combination of a weak yen, the rebound in long-term yields, the fiscal challenges that need to be addressed, and the Bank of Japan’s (BoJ) monetary policy normalization process are part of the elements behind these movements.
To this is added the fact that, over the weekend, the country will hold early elections, which were called earlier this year by Sanae Takaishi, Prime Minister and leader of the Liberal Democratic Party of Japan (LDP).
“This move by Takaishi aims to assert control over her own party and coalition, in order to implement her multi-year reflation strategy. The markets rightly fear that giving her more political capital means more fiscal deficits and inflationary pressures, hence the massive sell-off in the bond market and the jump in stocks. The yen reflects the fear that the Bank of Japan may be hindered by the executive from normalizing real interest rates quickly enough to contain inflationary pressures,” explains Raphael Gallardo, Chief Economist at Carmignac.
For now, the current expansive fiscal policy and uncertainty on the political front highlight the structural obstacles the country is facing, including negative real yields and an already high level of debt.
“The new prime minister wants to take advantage of her very high current popularity rating to win seats for the Liberal Democratic Party and regain control of the Lower House against a Democratic Party for the People, the opposition party, which is unprepared,” adds Martin Schulz, Head of the International Equity Group at Federated Hermes.
Moreover, stocks reacted positively, boosting the “Takaichi Trade,” which includes the aerospace and defense, nuclear, cyber, and domestic exposure sectors.
“Although we have observed some yen depreciation, the restrictions on Chinese exports and the increase in inflationary pressures could negatively affect the confidence of Japanese households and businesses in the short term, so ensuring internal political unity in the long term could help Japan’s negotiating position internationally, especially with the upcoming summit between Japan and the United States. Among the risks we are observing are internal political gridlock and a further unwanted depreciation of the yen,” notes Schulz.
Implication for the Markets
To understand why this weekend’s Japanese election is important, it is necessary to reflect on the role Japan plays in the markets. First, after several decades, it seems to be breaking out of economic stagnation.
“Japanese equity valuations have been particularly affected by the persistent reflation scenario. In these environments, the relationship between interest rates and price-to-earnings (P/E) ratios tends to invert. This has caused the P/E ratios of Japanese companies to barely exceed 17 times over the past twenty years, compared to the nearly 20-times average over rolling 10-year periods recorded by U.S. equities,” explains Noriko Chen, Portfolio Manager at Capital Group.
Secondly, it should be remembered that Japan plays a significant role as a “major financier” in recent years through the large carry trade that many have taken advantage of as a technical strategy, and upon which much of today’s leverage has been built.
“By keeping interest rates at zero or even negative levels, the Bank of Japan allowed a large amount of trillions of dollars to flow into risk assets around the world, especially the United States. Today, that cycle appears to be ending with the normalization of monetary policy, which is forcing the unwinding of massive positions,” states Laura Torres, Chief Investment Officer at IMB Capital Quants.
In view of the early elections this weekend, Ray Sharma-Ong, Deputy Global Head of Bespoke Multi-Asset Solutions at Aberdeen Investments, explains that if the Liberal Democratic Party (LDP) were to secure a majority and move forward with its fiscal agenda, several macroeconomic repercussions could be expected in the markets.
“Growth and aggregate demand will increase, driven by considerable fiscal stimulus and targeted investment in strategic sectors such as defense and energy. In addition, inflation expectations and Japanese government bond yields will rise, reflecting the market’s anticipation of a larger fiscal deficit, increased public spending, and greater uncertainty regarding the long-term fiscal path. And finally, the Japanese yen will weaken, as markets price in a weaker fiscal position, a larger fiscal deficit, and the possibility of a slower consolidation of public finances,” argues Sharma-Ong.
