Today’s headlines have been dominated by the news that Japanese prime minister Shinzo Abe has announced his resignation due to health reasons. While markets seem somewhat spooked by this, there’s reason to see this as a good entry point into Japanese assets rather than a reason to run away.
Abe’s health has been a topic in the news for some time now. I would argue that his stepping down on his own terms is less destructive than were it to happen as part of an unexpected political shake-up. In response to the announcement, we’re seeing Japanese equity markets down, the JGB (Japanese Government Bond) curve steepening and the Yen up slightly against both the Euro and the Dollar. To me, this seems like a good entry point for a number of reasons. The JGB curve has been steep for some time now and it seems unlikely that the Bank of Japan (BOJ) would tolerate a sharp deviation from their yield targets for too long. As of this week, they have also vowed to retain their current pace of bond purchases throughout September, providing support to the rates markets. As for equities, Japanese large cap stocks have some of the strongest balance sheets globally, and so a significant destabilisation of equity markets in the medium term also seems unlikely.
Some relatively higher volatility in Japanese markets would not be unexpected in the medium term as Japan goes through this political transition phase but, in my view, big shifts in monetary policy seem unlikely going forward. When Japan embarked on its ambitious monetary easing and regulatory reform a couple of decades ago (eventually labelled ‘Abenomics’), the country positioned itself as one of the few low-rate markets globally and became a region of stability during risk-off periods. Now, with global rates having fallen in line with Japan (‘Japanification’), a large shake-up in monetary or fiscal policies seem unlikely, especially in regard to the BOJ’s commitment to JGB curve control.
The COVID-19 pandemic, which triggered the worst quarter of economic contraction on record (Q2 2020) in Japan, has undoubtedly made the situation more complicated. Likely to be the focus in the short term is how Abe’s successor deals with the increase in virus cases in recent weeks, something which has been negatively impacting Abe’s approval rating. Interestingly, there is one positive outcome for markets from the pandemic: as a result of Japan’s lagging economic recovery, the Japanese economy minister Yasutoshi Nishimura has announced that he has no intention of further raising sales tax rates. This was a controversial policy from Abe that initially came under fierce criticism for being imposed when Japan looked to be on the brink of a recession even pre-crisis.
There are a number of possible successors to whom markets are likely to react differently. Those from Abe’s inner circle (e.g. chief cabinet secretary Yoshihide Suga or finance minister Taro Aso) would likely continue the policies that the current administration has put in place to combat the pandemic in Q3 and Q4. Options like LDP policy chief Fumio Kishida and former defence minister Shigeru Ishiba are considered more disruptive to markets due to their stance on fiscal austerity. In the case of defence minister Taro Kono and Toshimitsu Motegi, foreign minister, markets would likely react positively due to their support on aggressive fiscal policy.
I don’t expect the Yen to behave too differently versus the last few months. Now that FX liquidity has improved globally and volatility has come right down in developed market currencies, the Yen has somewhat recovered its status as a safe haven currency, having lost that title to the dollar for some time (see my previous blog on how the yen was behaving at the beginning of the current crisis). That the Yen is up slightly today may be due to JGB steepening. Though this Yen strength could continue, I don’t expect investors suddenly to enter into Yen carry trades, nor expect real rates to rise meaningfully, as this steepening is unlikely to be sustained (and the relationship between FX and yield differentials is relatively loose at the moment).
If Abe’s successor does decide to shake up monetary policy and adopt a more hawkish approach, this could be positive for the Yen and could be a way to tackle the decades of cheap loans that have kept unproductive companies alive and productivity gains low in Japan. But given perpetually low inflation and the current pandemic, this seems rather unlikely. It is also important to note that, in my view, Japanese FX markets have so far been pricing in macro risks more accurately than government bonds and credit spreads over the crisis, so I’d expect USD/JPY and EUR/JPY to remain fairly rangebound rather than react aggressively to further news. If the Yen were to depreciate (for example if equity markets were to pick up again), a possible outcome is that this could spur inflows into inflation-linked government bonds (JGBIs), which could help push up heavily negative breakevens.
Overall, while this is a sudden change and likely to be the start of a news-driven period of transition for Japanese markets, in reality this wasn’t the biggest shock of the year. In my view, it is more an opportunity to gain exposure to a market with relatively solid fundamentals, with room for technical support and mean reversion in both equity and fixed income markets.