investment insights

    Japan’s rising prices and diverging central bank policy

    Japan’s rising prices and diverging central bank policy
    Stéphane Monier - Chief Investment Officer<br/> Lombard Odier Private Bank

    Stéphane Monier

    Chief Investment Officer
    Lombard Odier Private Bank

    Key takeaways

    • At 2.5%, Japanese inflation exceeds the BoJ’s target for the first time in at least a decade
    • The yen will remain weak for the rest of 2022 and is politically sensitive ahead of a 10 July election
    • Yen weakness is politically sensitive ahead of a 10 July election
    • We await more evidence that decades of deflation are past, which may be a positive catalyst for Japanese equities.

    After decades of deflation, Japanese consumers are experiencing rising prices. The cost of Umaibo, a popular maize snack, increased in January for the first time since its 1979 launch, by 20%. In October, Asahi Breweries, one of the country’s largest beer makers, plans to increase prices by as much as 10%, the first rise in 14 years.

    For a second consecutive month, in May Japan’s headline consumer price inflation rose 2.5% compared with a year earlier. Higher commodity prices worldwide, in combination with the weaker Japanese yen, have lifted the import costs of energy and consumer goods. A survey of food products showed last week that prices this year have increased as much as 15%.

    Until this year, the Bank of Japan’s (BoJ) target of an annual 2% rise in inflation, set in January 2013, looked unachievable outside the temporary spikes seen during periods of consumption tax hikes. Now, for the first time since Governor Kuroda Haruhiko took office, inflation has reached its target and is likely to remain there for the rest of his ten-year term, ending in April 2023 (see chart 1).

    Inflation has reached its target and is likely to remain there

    Monetary policy and its potential contribution to the rising cost of living has become a political topic in Japan as in other developed economies. Voters, unused to inflation and often reliant on fixed income, have an opportunity to voice their concerns when they elect half of the parliament’s upper house for a new six-year term on 10 July. Mindful of this risk and worried by the yen’s depreciation, Prime Minister Kishida Fumio has promised more relief for households and businesses. In the meantime, Mr Kishida opposes any rise in interest rates, saying that would hurt Japan’s almost 3.6 million small and medium sized enterprises.

    The BoJ’s stark divergence from other central banks demands more nuance in policy communication. To fight rising inflation in the UK, US, and eurozone, where annual price rises were 9.1%, 8.6% and 8.1% respectively in May, central banks have lifted, or plan to raise, interest rates at the fastest pace in nearly four decades. For now, the BoJ is determined to maintain its accommodative measures and has accelerated Japanese government bond (JGB) purchases. The bank said it will continue “as long as it is necessary” to keep inflation above its 2% target “in a stable manner.”

    The BoJ remains the last dove

    A dove among hawks

    The BoJ remains the last dove among its developed market peers due to Japan’s unique macroeconomic circumstances. While we expect an economic rebound, it is too early to point to excess demand. After all, Japan experienced economic contraction in the first quarter following the shocks of a new Covid wave and the Ukraine war. Both the government and BoJ argue for continued loose monetary policy, making a rise in short-term interest rates to 0% unlikely, as it would be seen as the start of a hiking cycle.

    On 17 June, the BoJ committed to keep buying benchmark 10-year JGBs in order to hold yields below a target ceiling of 0.25%, in a mechanism known as ‘yield curve control.’ As we write, the bond yields 0.23%, compared with 0.045% at the start of 2022. Historically, the central bank has widened its target range when global yields stabilised, and we expect the BoJ to raise its ceiling to 0.50% before the end of 2022 (see chart 2). Meanwhile, the equivalent US Treasury bonds now yield more than 3.2% and investors have sold record amounts of Japanese bonds.

    If Mr Kishida’s ruling Liberal Democrats win more support on 10 July, markets expect a mandate for three years of uninterrupted rule to support the BoJ’s dovishness. However, an election victory may encourage Mr Kishida to push his own economic policies in a more consumer-friendly direction, as suggested by his concerns over the yen’s weakness.


    No yearning for yen

    While defending monetary accommodation, Mr Kuroda has recently stopped talking about the weak yen’s positive economic impact. That may be because it makes imports more expensive and inflation higher at a politically sensitive time.

    Until the BoJ lets sovereign bond yields rise, the yen is likely to remain weak

    Until the BoJ lets sovereign bond yields rise, the yen is likely to stabilise around its current level of 135. The last time the Japanese currency was this low against the dollar was July 1998. That was followed by a yen rally, driven by a trade surplus and foreign direct investment inflows. This time may be different, as the Japanese balance of payments deficit suggests more weakness ahead.

    We see the dollar-yen at 135 for the year’s end, trading in a volatile 130-140 range. The dollar’s strength should persist, as tighter US monetary policy underpins its haven status. Longer term, slower US monetary tightening, or the prospect of a recession in the US and Europe, could strengthen the yen. 


    Taking stock

    Japanese equities have fared relatively well this year. In local currency terms, they have fallen about 5%, passively outperforming the rest of the world. However, adjusted for yen depreciation, foreign investors in Japan are no better off.

    What is weighing on Japanese stocks’ prospects? Despite its recovery potential, earnings revisions depend on global activity, which is decelerating. Furthermore, Japanese companies are reluctant to pass on higher prices to customers. This increases margin pressures, keeping foreign capital away just as the BoJ reduces its passive asset purchases. We remain wary of global recession risks, slower Chinese reopening, or stalling wage increases.

    However, Japanese equity market valuations look relatively attractive. Companies’ retained earnings are increasingly being returned to shareholders via buybacks and the economic recovery will benefit many sectors. Overall earnings should grow by nearly 8% for 2022, similar to the US and Europe. Japanese cyclical and value stocks will remain driven by overseas demand, while financials may be supported by the expected change in BoJ policy. China’s economic rebound would benefit the Japanese car, steel and machinery sectors, with domestic recovery a positive for travel and retail.

    We monitor the potential positives of a reopening Japanese economy, higher yields, and a rise in corporate pricing power. Additional evidence that Japan is putting decades of deflation behind it would improve its long-term equity outlook. After adding exposure in the fourth quarter of 2021, for the time being we maintain a neutral stance in Japanese equities.

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