Abenomics key for Japan's economy in 2014

Could 2013 have brought an end to two lost decades for Japan? There has certainly been a dramatic reversal in investor sentiment, with many investors who had previously written the market off finally interested in buying again.

That has helped the Nikkei 225 index trounce the performance of the US and the UK, though it is still at well under half its 1990 peak.

The catalyst for the change has been prime minister Shinzo Abe and his recovery programme, dubbed Abenomics.

To find out how you can take advantage of Abe's new reforms, read: 15 ways to ride Japan's equity bull market.

On some measures, Abenomics has already been a huge success: while the Nikkei has rallied, the yen has devalued sharply, helping Japanese exports, which reached a three-year high last autumn. But GDP growth has been less dramatic and the trade deficit has widened, partly due to the costs of importing energy following the Fukishima nuclear crisis.

The key question for 2014 is whether Abenemoics can gather steam - or whether, like so many previous Japanese rallies - it will fizzle out.

Abe himself has talked about the programme having "three arrows" - fiscal expansion, monetary expansion and structural reforms to the economy.

"I'd say only one-and-a-half arrows have been fired [so far],' says Invesco's John Greenwood.

"'Fiscal expansion is working - although it will be partly reversed in 2014 when consumption tax is increased from 5 to 8%. The second arrow, monetary expansion, is the half arrow. It is easy to expand the Bank of Japan's balance sheet, and that is being done. The question is, will commercial banks take up the baton and increase their lending and monetary growth?

"The third arrow, structural change, is still in the quiver. Changes in the labour market are the key looking forward."

Growth slowing despite progress

There has been some progress: labour market reforms are being introduced and Japan is engaged in talks with the US over trade in Pacific countries. But the pace of growth - which had been rapid at the start of 2013 - is slowing.

Others, however, are less critical of the programme's progress. Fidelity's Trevor Greetham says: "I have always been a bit of an agnostic about the third arrow. I think it could better be described as 1,000 pinpricks - it will be very gradual and it could take five years to complete.

"The pinpricks are already happening: state pension funds are adding to their equity holdings and are seeking out companies with good managements and return on equity. That is a good incentive for companies to focus on shareholder value."

He is concerned about the impact this year's increase in sales tax - on everything from groceries to houses - will have; "but I think there is so much off setting policy activity that Japan could turn out to be one of the growth surprises", he adds.

Witan's Bell is also optimistic that Abe will manage to make the structural reforms that have eluded his predecessors: "Policy-making is coherent in a way that it has not been during the two grey and wasted decades. There are structural problems such as an ageing population, restrictions in wage and employment laws and inefficiencies in the service sector, but the government appears determined to make some inroads into these issues.

"If this, the so-called “third arrow” of policy, is deployed, the recovery in the economy (which has already been much greater than anticipated) could become selfsustaining, making Japan a contributor to global growth rather than a detractor. The market looks a fair one to back on current expectations, with scope to be re-rated if the economy reforms as well as reviving."

Invesco's Nick Mustoe points out that the reforms are already having a dramatic impact on the corporate sector, as the yen's weakness is stimulating exports. Earnings last year grew by 30% and forecasts for the current year are ahead of comparable companies in the rest of the world.

"Everyone has been very jaundiced about the prospects for economic recovery so companies were very lowly valued," says Mustoe. "While there has been a bit of a re-rating, there has been a lot of profit recovery. And analysts are in general cautious about raising their forecasts."

One of Japan's biggest bugbears has been deflation, which has proved resistant to previous policy measures. Even here there are encouraging signs, with the annualised rate over the second half of 2013 approaching 2%, and leading business indicators are positive.

While Japan was a fertile ground for investment in 2013, there could be more good news to come in 2014.

Japan fund recommendations

Baillie Gifford Shin Nippon investment trust: Baillie Gifford favours a long-term approach and this fund's success is built on that approach.

Invesco Perpetual Japan: Paul Chesson has a long record of managing money in Japan.

iShares MSCI Japan Monthly £ Hedged: Still a good-value entry fund to the market despite the extra cost of currency hedging.

To find out global outlooks for 2014, read: Outlook for the US in 2014, Outlook for emerging markets in 2014, Outlook for the Europe in 2014 and Outlook for Asia-Pacific in 2014.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.