Even after many successes, challenges loom in Japan
August 28, 2015
Shortly after Prime Minister Shinzo Abe was elected in 2012, he unveiled an ambitious strategy, now called “Abenomics” which consists of “three arrows” designed to lift Japan’s economy out of its deflationary doldrums. We provided an
outline for, and an update on, Abenomics
outline for, and an update on, Abenomics
outline for, and an update on, Abenomics
in November 2013, shortly after it had been implemented. Below is a further update on the country’s progress now that the first two arrows have had time to take effect.
The first two arrows — fiscal stimulus and monetary easing — were aimed at enhancing short-term growth and have resulted in some noticeable improvements in the economy.
During the next few months, Japan's Diet (or legislature), will work towards passing many of Abe’s wide-ranging reforms contained in the third arrow. Key initiatives include structural measures to improve competition, deregulate long-protected markets, break up government monopolies, decrease corporate taxes, increase workforce diversity, improve trade partnerships, cope with the challenges of a shrinking workforce, improve healthcare, and boost productivity by making it easier for companies to hire and fire employees.
Significant developments include reforms within each of the following categories:
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Labor market and productivity
Japan’s manufacturing companies in export-oriented sectors are admired for their efficiency and global competitiveness. However, productivity is much lower in the service industry which accounts for more than 70% of gross domestic product (GDP) (source: Bloomberg). Lifetime employment policies, the seniority wage system, a low female worker participation rate, and aging demographics have hindered productivity. In addition, the country’s nationalistic culture discourages immigration. Abe wants to more than double productivity growth in the service sector by 2020.
- Proposed reforms include tax incentives to encourage more women to join the workforce and, in turn, allow Japanese families to sponsor foreign workers to care for children and the elderly.
- Abe has set a target of 30% female representation in leadership roles by 2020.
- The Labor Ministry is investigating more effective ways to replace current employment policies with a merit pay system.
More than 25% of Japan’s population is already 65 years-or-older. By 2025, healthcare costs are expected to have risen 50%. (Source: Ministry of Health, Labour and Welfare in Japan.)
- The recent increase in the consumption tax will offset some, but not all healthcare costs.
- Top wage earners in major corporations will pay higher healthcare insurance premiums based on their income to help support a special, separate healthcare system for people who are over 75.
- Regulatory approvals will be accelerated and innovative medical devices and pharmaceuticals will likely be rewarded.
The powerful influence of Japan’s agricultural cooperative has been reduced. The group has used its political clout to control farmers and oppose modernization of Japan’s arthritic agricultural sector. We believe this should pave the way for innovation across Japan’s small, but important agriculture sector.
The Trans-Pacific Partnership (TPP)
Trade barriers discourage domestic companies from learning to become globally competitive. One of the key initiatives of this pending economic partnership between the United States, Japan, and 10 other countries from Asia and the Americas will be to lower trade barriers such as tariffs.
Positive results so far include:
- $210 billion has been allocated to large-scale public works projects as well as private investments.
- The Bank of Japan will continue its quantitative easing (QE) program, purchasing government debt until the inflation target of 2% is reached. To date, however, QE has resulted in a 40% depreciation of the yen against the dollar since Abe was elected in 2012, which has boosted exports. The central bank also announced in July 2015 that it will continue to expand the monetary base by 80 trillion yen ($648 billion) annually.
- Companies have begun to unravel their cross share-holding structures, which have stifled innovation.
- Minimum wages have increased by 6.5% since Abe was elected in 2012.
- The unemployment rate has fallen from 4.3% at the end of 2012 to 3.4% as of June 30, 2015.
- 250,000 women were added to the Japanese workforce in June. Female employment is now at an all-time high.
- Housing starts have increased more than 16% for the year ended June 30, 2015, helped by low mortgage rates and increased incomes.
- Return on equity for Japanese companies has steadily increased since 2012.
- Increasing share buyback programs, dividend payments, and merger and acquisition activity by Japanese companies indicate management’s attention to shareholder returns.
- More outside directors have been appointed to corporate boards.
- The $1.1 trillion Government Pension Investment Fund (GPIF) had more than 10 times as much money in the JPX-Nikkei Index 400 at the end of March than it did a year earlier. The GPIF raised allocations to domestic and foreign equities substantially away from domestic bonds.
- For the period ended June 30, 2015, the Nikkei 400 returned 14.9% in U.S. dollar terms through June 30, 2015.
- Since Prime Minister Abe was elected on Dec. 12, 2012, the Nikkei 225 index has increased by 49% in U.S. dollar terms for the period ended June 30, 2015.
- The estimated number of international visitors to Japan in June 2015 increased 51.8% from the previous year.
(Data sources: ISI, Japan Cabinet Office, Bloomberg, The Wall Street Journal, and Japan National Tourist Organization.)
Risks/causes for concern:
- Weak global demand and sluggish growth in China could slow Japan’s recovery. Japanese manufacturing activity contracted slightly in June indicating the economy may have lost some momentum.
- Japan’s national debt exceeds $8.6 trillion, which is more than 55% of GDP. If interest rates rise, it could be very difficult to pay down the debt.
- Powerful interest groups representing farmers, physicians, civil service employees, and corporations may continue to oppose Abe’s plans.
- Abe’s approval rating plunged below 40% in polls taken in July after he presented bills to Japan’s Diet to strengthen the country’s military.
- Depreciation of the yen has increased exports but raised the price of imports (oil), which dampens consumer spending. However, other countries also may weaken their currenciesweaken their currenciesweaken their currencies, as China has recently done. A potential currency war could make the competitive environment very difficult for export-oriented companies in Japan.
- Last year, labor unions voted to reject Abe’s proposals designed to make it easier to fire employees.
Data sources: Bloomberg.
As these reforms are successfully passed into law, the government will still need to work with long-established cultural traditions that often make change difficult to achieve. Although many of the initiatives are ambitious, they offer Japan a chance to revive its lackluster economy and become globally competitive once again.
A key challenge to forecasting performance in today’s environment lies in anticipating the interaction of economic activity, policy action, and market participants’ perceptions of both. We embrace buying opportunities in out-of-favor names, but with a careful eye toward risk. In the current environment, we remain focused on what we view as strong companies with consistent, sustainable cash generation. We also seek opportunities for profit-margin expansion through cost control in addition to exposure to cyclical recovery. These characteristics help to distinguish those companies that have self-sustaining business models and retain some measure of insulation from the uncertainties of the market cycle.
The views expressed represent the Manager's assessment of the market environment as of August 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The JPX-Nikkei Index 400 was jointly developed by Nikkei, Japan Exchange Group and Tokyo Stock Exchange. It is composed of companies that meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives.
Indices are unmanaged, and one cannot invest directly in an index.
The Nikkei 225 Stock Average is a price-weighted index comprised of Japan's top 225 blue-chip companies on the Tokyo Stock Exchange.
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