wisdomtree 2016 japan 10 surprises jesper koll

2016: Ten Surprises for Japan

BY JESPER KOLL

It is the time of year when economists and strategists present their forecasts and baseline scenarios for the year ahead, 2016.

Quantitative forecasts are based on de facto probability models, and qualitative scenarios are based on, well, a combination of

experience and common sense. Either way, most methodologies leave little room for a discussion of true outliers and surprises.

This list of “2016: 10 Surprises for Japan” is trying to address this deficiency. Here are the “out of consensus” scenarios that I

personally worry about as possible inflection points for Japanese investment strategy. By definition, they carry probabilities that

may be one or two standard deviations1 away from the market’s baseline assumptions; however improbable today, any movement

toward their far-out targets may well trigger major inflections in Japanese markets. Their primary purpose is to stimulate the reader

to “watch out for the unthinkable.”

Enjoy and best wishes for a healthy, happy and prosperous 2016.

1) 4% NOMINAL GROSS DOMESTIC PRODUCT (GDP) GROWTH

Nobody expects high growth in Japan. Most forecasters doubt Prime Minister Shinzo Abe’s target to push up GDP from the

current ¥500 trillion to ¥600 trillion can be achieved in the foreseeable future. Abe benchmarks around 3% nominal GDP growth per

annum, but by the end of 2015, the consensus forecasts not even half that rate of growth for 2016. So a growth spurt with nominal

GDP surging to a 4% run rate by mid-2016 would come as a real surprise.

Possible? I would not rule it out. Take the combination of added fiscal boost, a slingshot start on capital investment, plus pent-up

demand from retail consumers, and you could quickly end up with a domestic economy firing on all cylinders in early 2016. True, in

2015 neither tight labor markets nor record corporate cash balances ended up feeding demand, but in turn, the austerity and cash

hording of 2015 may very well have increased the de facto purchasing power for a 2016 demand surge.

For equity markets, a Japanese growth spurt would be a positive surprise, with neither the domestic nor global investor positioned

for it, in our view. Yet the real surprise may come from the Japanese government bond2 (JGB) market: It is unlikely that 4% nominal

GDP growth can work together with 10-year bond yields stable below 0.5%. That would be a really surprising consequence of a

Japanese growth spurt surprise.

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WisdomTree Research MARKET INSIGHTS [ December 2015 ]

1 Standard deviation: measure of how widely an investment or investment strategy’s returns move relative to its average returns for an observed period. A higher value implies more “risk”, in that there is more of a chance the actual return observed is farther away from the average return.

2 Japanese Government Bond (JGB): A bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.

2) JAPAN’S CURRENT ACCOUNT3 DEFICIT RETURNS

2015 brought the return of trade and current account surpluses to Japan. With energy prices low, some nuclear reactors back on

line and exports stable to modestly growing, the consensus appears to expect a further expansion of this trend. A drop back into a

balance-of-payments deficit would come as a surprise, with possibly big implication for a weaker yen.

Possible? Exports are driven by global growth in general, U.S. car sales in particular. Here, not only is the U.S. car cycle already very

late stage, but the relative market-share gains for Japanese makers at the end of 2015 appear largely due to a drop-off in sales from

the major German competitor. This may well turn out to be just a temporary plus for exports; no doubt, the Germans will fight back

in 2016, and the euro currency weakness is poised to translate into powerful ammunition to create price competition advantages for

German makers before long. Meanwhile, Japan’s import bill could also be under more upward pressure than expected: If domestic

demand starts to increase, the decade-long structural shift toward offshore production for many Japanese capital and consumer

goods companies should trigger much faster import demand pull than observed during previous cycles. Japan’s aggressive

offshoring is poised to have raised the import elasticity substantially, which in turn raises the probability of higher imports forcing

trade and current account deficits as domestic demand recovers. Add to this the growing possibility of a reversal in the terms of

trade as the 2015 drop in energy and commodity prices begins to fade from year-over-year comparisons.

If a Japanese trade or current account deficit comes back into sight, the case for yen depreciation is poised to get stronger, with or

without added stimulus from the Bank of Japan (BOJ).

3) WAVE OF JAPANESE FINANCIAL COMPANY MERGERS

Japanese finance is under pressure to develop a fundamentally new business model. Pressure is building from all sides: The unwinding

of cross-shareholding directly undermines the traditional main-bank relationships; the demographic destiny of regional economies is

eroding future business development for regional financial services providers; there is increasing competition from the privatization

of Japan Post; and on the macro side, the shift from deflation to inflation is bound to drive a shift away from deposit-based finance

toward direct finance. Many forward-looking dynamics suggest that Japan’s financial system is overbanked, overbrokered and

overinsured. A real surprise would be if 2016 marks the start of a broad-based and deep-rooted wave of consolidation—not just

among regional banks, but cutting all the way into megabanks, major investment banks, asset managers and insurers.

Possible? I am convinced that a consolidation wave will come sooner or later, but one key force delaying it maybe the lack of

clarity on the future global regulatory framework for universal banks and integrated financial services providers. Still, even with this

lingering uncertainty, a roll-up merger wave among regional banks is most likely to accelerate and, in my personal view, I would not

be surprised to see some of the megabanks beginning to increase their nationwide reach by buying more local players.

If the visibility of a financial services consolidation wave rises in Japan, the market implication could be that Japan’s financial sector

moves toward becoming a top-performing sector for 2016, in my personal view.

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3 Current account: The difference between a nation’s total exports of goods, services and transfers, and its total imports of them.

4) A JAPANESE “HACKER” BREAKS THE GLOBAL CYBERTERROR NETWORKS

The war in cyberspace is real, with cyberattacks on corporate, private and public networks now the biggest “known unknown” challenge

for risk managers and leaders everywhere. So far, Japan appears as a relative latecomer to cyberwar prevention and countermeasure

development, but this started changing in 2015 with both public policy and private initiatives beginning to focus on the problem. A

real surprise would be if a team of Japanese hackers cracks a key code of cyberterror and develops a credible early-warning system

that can predict or even stifle future attacks.

Possible? While few engineers or investors doubt Japan’s prominence in robotics, the real-world reputation of Japanese software

developers and hackers is much in need of a big showcase win. A global breakthrough coming from Japan would be a real surprise. It

would, however, almost certainly raise the ambition and popularity of Japanese youth to pursue more software and IT-related careers.

5) PM ABE CALLS DOUBLE ELECTIONS AND WINS BY A LANDSLIDE

In July 2016, one-half of Japan’s upper house of parliament is due to stand for election. Unlike the fixed-cycle election rule for the

upper house, Japan’s lower house election cycle rests de facto in the hands of the prime minister. He can call an election whenever he

deems most opportune. Prime Minister Abe won a landslide two-thirds majority at the end of 2014. For 2016, a big surprise would be

if he dissolves the lower house and calls a “double election.” Conventional wisdom argues against taking this risk, and Abe himself

recently suggested he is not currently thinking this way. What would change his mind?

Tactically, the more the economy recovers and creates a real “feel-good factor,” the more likely a snap election becomes. A key

indicator could be a surge back toward 60% in Abe’s popularity (currently around 45% to 50%). Note here that Japan will host the

2016 G-7 Summit meeting May 26–27, which could well boost Abe’s popularity and reputation as a global leader in the eyes of the

Japanese people. Strategically, Abe may be tempted to go for a “double” because the opposition parties remain in disarray and

without funding. He may also want to get the election out of the way before the next hike in the consumption tax, slated for April 2017.

In our view, a “double election” would be a surprise, but if it happens it would probably be good news for markets. We think so

because we are convinced that “Team Abe” will only call an election if the probability of a major landslide victory in both the lower

and upper house is very high indeed.



6) MINISTRY OF FINANCE (MOF) AND BOJ AGREE TO RESTRUCTURE JGBS INTO “ZERO-COUPON PERPETUAL BONDS”

The Bank of Japan is mopping up government debt like few other central banks have done in history. Is there an exit? What is

the endgame? Over the coming months, the Federal Reserve’s first concrete moves away from quantitative easing4 may prove

valuable lessons for what the BOJ will have to face eventually. A real surprise would be if Japanese technocrats decide to pre-empt

this debate and propose a more proactive course for Japan. If both MoF and BOJ agree to restructure the BOJ-owned JGBs into

“zero-coupon perpetual bonds,” the Japanese fiscal-monetary nexus could keep running without markets having to worry about

the eventual exit.

Possible? Surely it would be a very radical step with little historic precedent. However, if, against expectations, the Fed’s balance

sheet “normalization” causes greater-than-expected financial disturbances, a more pragmatic cooperative approach between the

treasury and the central bank could well become possible in Japan, in our view.

If so, the implications for the bond market maybe less significant than the possible impact on the currency: Yen currency devaluation

risks would rise significantly, in our view.

7) “ABENOMICS5” WINS THE NOBEL PRIZE FOR APPLIED ECONOMICS

This, of course, would be an incredible surprise. There simply is no such thing as a Nobel Prize in applied economics. Academics

get rewarded, not practitioners. Still, my point is that, at the end of 2015, few commentators and strategists believe Abenomics

will be successful. For 2016, a surprise would be a reversal of this. In media commentary, this would be reflected in increasingly

positive commentary on how Abenomics is working and how it could become a model for other countries’ leaders of economic

policy. Could the G-7 Summit hosted by Japan in May be the launchpad for such a campaign?

In Japan’s equity markets, this would be reflected in the development of an “Abenomics premium” (i.e., price-to-earnings

multiple expansion).

Possible? In our view, global opinion leaders still very much underappreciate the pro-business policy drive and expert coordination

of all levers of policy—monetary, fiscal and regulatory. Both global and domestic investors are still structurally under-weight

Japanese risk assets, in our view. Add to this the increasing credibility of Abe-led private and public sector partnership, and you

end up with a strong case that, yes, Abenomics may very well turn out to be the most impactful and far-reaching structural growth

policy program in place in any of the advanced industrial economies in today’s real-world free-market parliamentary capitalism.



4 Quantitative Easing (QE): A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity.

5 Abenomics: Series of policies enacted after the election of Japanese Prime Minister Shinzo Abe on December 16, 2012 aimed at stimulating Japan’s economic growth.

8) U.S.–CHINA POLICY COORDINATION

The U.S. dollar remains the global anchor currency and, as the Federal Reserve (Fed) begins to hike U.S. interest rates, the de

facto impact will be a tightening of financial conditions for many emerging market economies. The risks of U.S. rate hikes deflating

global growth are of significant concern for many forecasters, including the International Monetary Fund and the World Bank.

Nobody is forecasting an offsetting counter-policy response. So it would come as a real surprise if the People’s Republic of China

were to step in and present a sizable fiscal expansion program. In many ways, a Chinese fiscal demand boost would be a most

credible global insurance policy against the negative impact of higher U.S. rates. Almost certainly, it would translate quickly into

higher demand for many of the emerging economies’ exports.

Possible? During the “Lehman shock” crisis, China did indeed answer the need for global demand stimulus with a massive

Keynesian-style stimulus that helped turn the crisis-induced downturn into the next upturn. Whether at this point in the cycle China

could be counted upon is not clear. However, 2015 brought the China-led establishment of the Asian Infrastructure Investment

Bank. It is highly probable that 2016 will bring the first concrete positive demand-pull projects coordinated by this new pro-growth

institution. So even without open U.S.-China policy coordination, the de facto policy drive led by China could lead to positive

growth surprises in 2016–17, particularly for Asian emerging markets, in our view.

9) TRANS-PACIFIC PARTNERSHIP (TPP) GETS BLOCKED BY U.S. POLITICAL INFIGHTING

The impact of the Trans-Pacific Partnership free-trade agreement on Japan’s economy is broad-based and deep. It ranges from

tariff cuts on agriculture to intellectual property protection and protection against unfair competition from state-owned enterprises.

Full implementation is, in our view, one of the important change agents toward greater productivity and a higher potential growth

for Japan. A surprise, if not a shock, would be if U.S. lawmakers block the TPP from coming into law. On top of the potential

negative impact on Japan, the bigger negative surprise would be possibly irreparable damage to America’s leadership credentials

in Asia-Pacific, in our view.

10) A JAPANESE MEDAL IN THE 100M OR 200M OLYMPIC SPRINT

2016 will bring the next Summer Olympics. Japan has plenty of sports talents but has never done well in track and field events in

general, short-distance sprinting in particular. However, change is afoot. A real surprise could be Japan’s youth sprinting sensation

Abdul Hakim Sani-Brown-san winning a medal in Rio. Born in Fukuoka to a Japanese mother and a Ghanaian father, the 16-year-old

broke Usain Bolt’s longstanding 200-meter world youth record in 2015.

Possible? This upcoming Olympics is definitely an aggressive call for a 17-year-old boy to become the world’s fastest man. However,

I am very confident all this means is that my prediction is just a little too early. At the Tokyo Olympics in 2020, Japan’s sprint ace

Sami-Brown-san will be right up there in the center of the medal podium—and that is a forecast, not a surprise.





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