Big spending and easy monetary policy proponent wins LDP leadership race
Japan’s ruling Liberal Democratic Party (LDP) elected Sanae Takaichi as its new leader on 4 October, positioning her to become the country’s next prime minister. Given her support for expansive fiscal policy and monetary easing, Takaichi’s victory sparked a rally in Japanese stocks. At the same time, the OIS market started to price out expectations for near-term Bank of Japan (BOJ) interest rate hikes. In the currency market, the yen came under renewed pressure, hitting a record low against the euro. Investors appear to be pricing in Takaichi’s embrace of “Abenomics” into their expectations for her leadership. However, long-term Japanese government bonds have come under pressure, providing a warning against one-way expectations of concerted Abenomics-style macroeconomic stimulus.
Fiscal policy may be supportive
From a fiscal standpoint, the new LDP leadership—and the prospect of a new prime minister, who would lead the minority government later this month—has some reason to support moderately easier fiscal policy. While opposition parties are not united politically, they have been aligned in their calls for additional stimulus to help ease the impact of higher prices on households. One commonly cited measure is an increase in the maximum tax-free income allowance. Such moderate and temporary stimulus may support Japan’s domestic economy. However, the bond market may not welcome any signs of a shift away from recent fiscal discipline, which has been reflected in an improvement in the debt-to-tax revenue ratio. With term premiums already rising, particularly at the long end of the yield curve, investors may push back against any perception of excessive fiscal largesse. In this sense, it is possible that the bond market may act as a check on overly aggressive spending.
Conditions are different from early days of “Abenomics”
For the BOJ, the challenge of managing inflation that exceeds its target remains unchanged. As we witnessed at the last BOJ meeting, some members dissented against the central bank’s decision to keep overnight rates unchanged, favouring a rate hike to keep inflation expectations in check. Amid growing global scrutiny of central bank autonomy, the BOJ may eventually face pressure to demonstrate that it is not falling “behind the curve” on inflation. The current steepening of the yield curve may be a warning.
The underlying conditions in the economy and markets today are markedly different from 2012, when Prime Minister Shinzo Abe assumed the LDP leadership. In December of that year, Japan had experienced two decades of deflation and zero-growth stagnation, with negative inflation expectations. Dollar/yen traded below 100 and the unemployment rate was at 4.2%, more than a percentage point higher than today. In contrast, Japan now faces an acute labour supply shortage and above-target inflation. This means that nominal wages not only need to rise to keep household income growing, but also have to keep up with rising prices—which is directly tied to the BOJ’s inflation-fighting mandate. It is likely that a seasoned politician such as Takaichi will pay some heed to these important differences between then and now.
Meanwhile, the AI-centred capex boom dominating US equities continues to be in the background of the Japanese stock market rally. Such enthusiasm has overshadowed weaker signals from the US labour market. US stock market valuations are buoyed by strong US earnings and expectations of continued economic spillover from AI investment. The current state of stock market valuations contrasts markedly with the multiple Federal Reserve rate cuts priced in for the coming year, which imply a considerable economic slowdown. Paradoxically, the anticipation for lower rates appears to have supported current US stock market valuations and may have spilled over into other markets. Yet, both views cannot coexist indefinitely. To the extent that this contradiction has made a marginal contribution to the ongoing stock rally, there may be some room for an interim correction.
That said, we remain positive on the trend for Japan and Japanese equities. We continue to be confident in Japan while remaining vigilant over the market’s near-term buoyancy and its potential to outrun fundamentals, which could lead to a corrective phase.