Abenomics: Having Real Impact but Misses Opportunity on Cutting Corporation Tax

The key area of my investigation during my recent trip to Japan was how much positive impact "Abenomics" was actually having on companies and consumer sentiment.

Abenomics is a series of measures introduced by new Prime Minister Shinzo Abe to lift the Japanese economy out of stagnation and chronic deflation.

I think Abenomics is having a real impact.

Abe is still very popular and Haruhiko Kuroda, the new governor of the Bank of Japan, is determined to achieve his goal of 2% inflation.

The recent volatility in Japanese equities has made investing in Japan look risky but in my view, Japan still offers a real recovery story.

Having An Impact

The domestic economy is noticeably recovering. Some of this is a natural bounce back from the weakness that resulted from the island dispute between Japan and China in the fourth quarter of 2012.

However, there is clearly an underlying recovery in economic fundamentals - consumer spending and housing starts are both strong and many companies are planning to increase capital spending sharply this year.

Consumer sentiment is rising, helped by an approximately 7% increase in summer bonuses, which is the biggest rise since 1990, and some nascent and sporadic signs of wage growth. Expectations that the Abe administration will implement real change are another factor behind the improvement in consumer confidence.

Inflation is beginning to emerge, although admittedly this is mainly imported inflation on the back of a weaker yen. For example, Apple recently raised the yen price of its iPad by about 20%.

I expect corporate earnings to rise sharply this financial year to March 2014 on the back of a better domestic economy and significant benefits from the weaker yen. Nomura has predicted the average earnings per share for Topix constituents to be ¥82.5, a 66% rise, this financial year, assuming a yen per US dollar rate of ¥100.

The average price to earnings (P/E) ratio of the market is currently about 13x Nomura's forecast earnings.

Missed Opportunity

There has been some disappointment about the contents of Abe's policy targeting structural reform and domestic growth. But I think the extent of reform is widespread and will be positive for the long-term growth of the economy.

The only missed opportunity is a lack of any commitment to cut corporation tax. This may still be announced after the Upper House election in July as a tax cut has previously been strongly hinted at by the Abe administration.

Fundamentals

Following the recent volatility, the Japanese market looks undervalued again, trading at around 13x forecast earnings estimated by Nomura and on a prospective dividend yield of 2.3%.

The recent strength of the yen against the US dollar does not seem to reflect economic fundamentals. Japan is significantly boosting its monetary base, while the US is likely to be reducing its quantitative easing programme over time.

As a result, the yen is more likely to weaken against the US dollar over this financial year.

I believe large-scale selling by domestic institutional investors has caused much of the recent excessive volatility.

They have now reduced their equity positions and at the same time have raised their target weighting in Japanese equities. This seems to have taken the downward pressure off the market.

Key Risks for Failure

Abenomics may fail if wage growth falters. The market needs to see wage rises across the board to offset the cost-push inflation and boost consumer confidence. Wage rises are an important part of the solution.

Abenomics might encourage a raft of opportunist fund raising by companies that do not need to raise funds. We have already seen a small number of these. Fund raising could absorb any increase in demand for equities and hinder the progress of the stock market.

The key risk remains Abe himself.

Assuming Abe wins the Upper House election he then has three years without any election and would be in a strong position to implement his own vision of an improved Japan.

If he becomes mired by constitutional reforms or if he has to step down for any reason, I think this will dramatically weaken Japan's recovery story.

Simon Somerville, Manager of the Jupiter Japan Income Fund at Jupiter Asset Management Limited.