Stéphane Monier, chief investment officer at Swiss private bank Lombard Odier, and portfolio managers Iain Cunningham and Alex Holroyd-Jones at Ninety One, an investment manager, discuss Japan’s economic prospects and the road ahead for its monetary policy.

Japan’s economy looks relatively healthy, giving the Bank of Japan an opportunity to wind down its yield curve control policy - in place since 2016, Stéphane Monier, chief investment officer at Lombard Odier, has said.

“With improving economic prospects that may outpace growth in the US and Europe in 2023, Japan is on a slow path to monetary policy normalization. Still, the BoJ has surprised markets as an outgoing governor navigates a path to change a more than six-year old strategy,” Monier said.

“Japan’s economy is looking relatively healthy. It has been less affected than Europe and the US by inflation, the war in Ukraine and energy market volatility. Its biggest export market, China, is reopening, promising a further boost,” he said in a note. “We expect the country’s gross domestic product to expand by 1.6 per cent over 2023, with average consumer inflation reaching 2.5 per cent, on the back of significant hikes to electricity tariffs. This is some way above market consensus estimates, and the central bank’s target for the second year running."

However, Monier believes that Japan’s economic growth is driven largely by consumer demand, so much depends on wages keeping pace with inflation, which by Japanese standards is exceptionally high. Two decades of low earnings' growth has made workers sensitive to rising prices. The annual round of industrial wage negotiations that start in February/March, known as ‘shunto,’ will therefore be closely watched. 

“Japan’s largest federation of trade unions asked for a 5 per cent rise in total pay in November but its initial demands are usually watered down,” he said. “Meanwhile, Japanese fashion brand Uniqlo said it would raise wages by an average of 15 per cent from March. A 3 per cent wage increase – the highest for some years – would bring salary growth to the level that the BoJ said in 2022 would be sufficient to generate a moderate and sustainable level of inflation. The first batch of the negotiation results will be released in March and provide the first clue on how workers’ pay will behave this year,” he continued.

Japan has flattered to deceive investors over recent decades - with several "false dawns" since its economy slumped after a real estate crash in the late 1980s. An aging population and associated desire to hold cash and similar assets has weighed on the economy. However, in recent years a variety of forces, such as corporate governance reforms, have encouraged international investors to give the country a fresh look. (See, for example, this commentary over a year ago from Matthews Asia, a business that is headquartered in San Francisco.)

BoJ’s December surprise
Along with very low inflation, Japan has had very loose monetary policy for more than six years. The BoJ also initiated its ‘yield curve control’ policy in September 2016, setting its target yield for the 10-year Japanese government bond to zero with a tolerance band of plus-or-minus 0.1 percentage points. 

“If there were a good time to drop the BoJ’s YCC policy, this looks like it,” he said. “The likely sequence for the BoJ’s ‘normalization’ path thus involves the removal of the YCC policy followed by more conventional monetary policy guidance for short-term rates, depending on the development of inflation and wages,” Monier said. 

“We do not expect any change before April, when Kuroda departs and the fiscal year ends. Doing so beforehand would mean large investors such as pension funds and financial institutions could see big swings in valuations of their JGB holdings. If conditions continue to point to on- or above-target inflation, the BoJ may end its negative interest rate policy, though not any time soon. We believe that an adjustment in short-term rates is still unlikely this year,” he said.

BoJ leadership and candidates
Attempts to anticipate BoJ policy are complicated as governor Kuroda’s 10-year term ends in March 2023. Until now, two names have been regularly mentioned as successors to take over at the BoJ’s April meeting: deputy governor Amamiya Masayoshi, or his predecessor, Nakaso Hiroshi. A third candidate and another former deputy, Yamaguchi Hirohide, is now being mentioned, the firm said. 

Whoever takes over from Kuroda faces difficult choices; the central bank’s YCC policy has been unpopular politically as it has contributed to a weaker Japanese yen, increasing levels of imported inflation. The appointment will be made by prime minister Kishida Fumio, and whichever candidate succeeds Kuroda, the firm’s expectation is that the BoJ will eventually move away from extraordinary monetary stimulus measures and abandon yield curve control.

Currency markets, equities
In 2022, a weakening yen and more competitive exports helped support Japanese equities. This year, however, Monier sees the yen strengthening against the US dollar, with the USD JPY trading around 120 by the end of 2023, from today’s 130. 

“The US Federal Reserve is slowing the pace of rate hikes while the BoJ is tightening policy. The yen is also benefiting from the economy’s improving terms of trade. It increasingly looks like an attractive alternative haven currency to the dollar,” Monier said.

A change of dynamic for the yen will have implications across markets, with a tailwind for Japanese equities becoming a headwind in 2023. In light of this, Monier favors sections of the market more focused on domestic demand than exports. 

The firm shifted its Japanese equity allocation from large cap to small and mid-cap stocks in November 2022. “The latter stand to benefit more from Japan’s improving growth outlook, as well as from increased foreign tourism and a stronger yen that would reduce the cost of imports. Specifically, we favor regional banks, real estate, transport, leisure, consumer discretionary stocks, and internet service and content providers,” Monier continued.
 
Ninety One
Asset markets and investors experienced a tough year in 2022. “One central bank to buck the tightening trend has been the Bank of Japan. Japan has not experienced the same degree of inflation, which means the BoJ has uniquely pursued easing while all other developed market central banks have been tightening,” portfolio managers Iain Cunningham and Alex Holroyd-Jones at Ninety One said. 

“The BoJ’s policy of ‘yield curve control’ involved printing unlimited amounts to cap the level of interest rates on 10-year Japanese government debt. This divergence in policy has led to significant weakness in the Japanese yen and, despite one of the worst years on record for global assets, the currency lost 14 per cent vs the US dollar and 7 per cent vs the euro in 2022,” they added.

“However, in our view, a change in Japanese policy is becoming highly likely. Japan has pursued an ultra-dovish policy because of a longstanding policy consensus to end deflation. Yet progress has been made on inflation and wage expectations are approaching a level not seen since the early 1990s,” they said. 

Meanwhile the BoJ has noted that the costs of easy policy may be outweighing the benefits due to the impact on domestic bond market functioning. This is occurring in the context of impending institutional change at the BoJ as the next two candidates for governor have more hawkish views than current governor Kuroda. 

“All of this is likely to lead to a turn and place significant upward pressure on the yen in 2023, especially since a change in BoJ policy will be occurring against the backdrop of other developed market economies entering a recession,” they concluded.