Why Japan is the biggest investment story of 2014
Japan’s economic reforms will have huge implications both at home and for its neighbours in Asia. Lars Henriksson explains what it means for investors.
"Ever tried. Ever failed. No matter. Try again. Fail again. Fail better."
The Irish playwright Samuel Beckett wrote that in 1983. I wonder whether Shinzo Abe, prime minister of Japan, is a Beckett fan?
Abe is the first former prime minister to return to office since 1948. He admits that he failed during his first term he was too eager to complete everything at once. On 12 September 2007, just three days into a new parliamentary session, he called an unscheduled press conference and resigned.
After six years travelling around Japan, Abe won a second term in December 2012. And it seems he took the lesson from his short-lived first term to heart. In June of last year, he invited a handful of people to his residence: a Paralympic skier who lost her leg in a car accident, a fisherman who became a community promoter after nearly drowning, and a young business owner with a successful new factory that replaced its recession-ravaged predecessor.
The theme that day at Abe's residence was the second chance'. It is emblematic of Abe's drive to revive Japan's once-thriving economy by better tapping into the people who have experienced failures or hardship just like himself.
When he was running for his party's leadership, he told fellow politicians, "I have died once, so I have nothing to lose I have nothing to fear".
Abe's fearless approach appears to have paid off. Since being re-elected, Abe set about reviving the economy by focusing on "three arrows" of reform, including monetary reflation, fiscal policy and structural reforms. And Abe is failing better': since the market learned about Abenomics just over a year ago, the Nikkei has risen by a staggering 75%.
And Abe's Japan has vital investment implications across the world, particularly in Asia.
The Japanese domino effect
Firstly, the lower yen. A weaker yen could lead to higher inflation, increased export competitiveness, higher GDP growth, and higher profits for companies in Japan. But perhaps most importantly, it could create a virtuous cycle of higher wealth and boost growth.
The yen has depreciated more than 25% since October of last year. That makes Japanese exports cheaper abroad and imports more expensive in Japan. Increased Japanese exports will boost production and foreign direct investments (FDI) in Asian countries where Japanese companies have a big presence. For instance, Japanese FDI is 2.1% of GDP in Vietnam, 1.3% in Singapore, 1.0% in Thailand and 0.8% in Hong Kong.
Japanese foreign direct investment in Asean countries (the Association of Southeast Asian Nations) reached $12.9bn in the first three quarters this year, up 130%. The main beneficiaries were Indonesia (+$3.1bn), Thailand (+$2.8bn), and Vietnam (+$2.8bn). In contrast, Japanese FDI to China was only $6.5bn in the same period, which is a 36.5% drop.
The second channel is reflation. This means putting an end to deflation in Japan and generating roughly 2% inflation. If successful, it would mean countries with high proportion of exports to Japan would benefit, such as Malaysia (8.8% of GDP), Vietnam (8.7%), Hong Kong (7.1%), Singapore (6.5%) and Thailand (6.4%). Higher asset prices could boost Japanese household consumption and tourism spending. Tourism spending from Japan, as a percentage of the country's GDP, is largest for Taiwan (0.5%), Thailand (0.5%) and South Korea (0.4%).
A key component to achieving this is higher wage growth. On Sunday, it was announced that Keidanren, Japan's most influential business lobby, had agreed to raise workers' wage base pay for the first time in six years.
Thirdly, portfolio flows may shift. Currently, Japanese investors are mostly keeping their foreign holdings in Central & South America (35%), Western Europe (27%) and the US (17%). Japan's holding of Asia is relative small at 3.6% and concentrated to investment grade countries like Singapore, Malaysia and Korea.
The Japanese authorities have proposed an Asean bond fund, which could help to provide significant support for bonds within that group. No details about size and timing are available yet.
Interestingly, the Bank of Japan is fairly restrictive of Japanese banks and insurance companies buying stocks and bonds in Asia, but more liberal regarding their taking direct stakes in related businesses. We have discussed some of them in previous issues and think there will be many more to come in 2014.
Buy what Japan wants
Well, in the past the motto was buy what China wants'. The main beneficiaries include commodity exporters such as Australia, Brazil and Russia, as well as Western multinationals selling technology and high-end consumer goods from the US and Europe.
That theme has now been exhausted. So I'm going to amend it to (the not very elegant-sounding!) buy what Japan wants (too)'. In this new scenario, countries that are part of the Japanese supply chain, or which sell to Japan, will gain.
I see the smaller Asian countries as the main winners. This is particularly true for Southeast Asia because they don't really compete head-on with Japan, but they do import a lot from Japan. Many of them have let their currencies depreciate in order to stay competitive in yen terms. On the other hand, Korea and Taiwan are more exposed and will need to work harder to stay competitive against their Japanese peers.
For Europe, the situation is more challenging because it competes more directly with Japan. Vehicles and vehicle parts, instruments, machinery and electrical components in particular are less likely to be imported from Japan. And Germany, the UK and Italy have the most export similarities.
Global fund managers are not positioned for that scenario. In the latest BoA Merrill Lynch fund managers' survey, the gap between the eurozone and emerging markets is extreme (way below 2001 and 2007).
This suggests that either bullishness about Japan is misplaced or emerging markets are ready to surge back in 2014. I know which argument I'm buying.