By James Liu, Global Market Strategist, J.P. Morgan Funds

Divergence in a country’s monetary and fiscal policy is not uncommon, and in Japan today the central bank is using loose monetary policy and balanced fiscal policy to stimulate its economy while simultaneously attempting to control its national debt. Investors considering the prospects for the Japanese economy and markets need to evaluate a range of countervailing forces. In the short term, further monetary and fiscal stimulus is likely to have a slightly positive impact on Japanese equities, while in the longer term, fiscal tightening could be a headwind.

Fiscal drag, monetary stimulus

When Japanese Prime Minister Shinzo Abe took office two years ago, he unveiled a strategy to revive growth in the Japanese economy. The “three arrows” of Abenomics: substantial fiscal and monetary stimulus, which have both taken effect, and structural reform, which has not. Abenomics sparked a boom in equity values and a plunge in the value of the yen, which is down about 30% vs. the USD since mid 2012.

Postpone the pain: a consumption tax hike is delayed

But Japan’s economic picture darkened in mid-November when second quarter GDP fell 1.6% on a quarter-over-quarter annualized basis, against a market consensus of positive 2.2% growth. The third quarter decrease in GDP follows a 7.3% drop in second quarter GDP, and puts the Japanese economy in a technical recession. Lower GDP reflects the fact that private consumption did not rebound as anticipated, largely because of stagnation in real incomes.

As expected, shortly after the weak GDP report Prime Minister Abe announced the postponement of the second increase in the consumption tax. In April the tax had jumped from 5% to 8% and it was on track to rise to 10% in October 2015. Instead, it is now scheduled to take effect in April 2017. Abe also dissolved the lower house of the legislature and called for a snap election to be held on Dec. 14. The Prime Minister will likely use the time to gain support for his policies from the leading political parties.

Additional fiscal stimulus was promised, but not detailed. We expect it will focus on increasing consumer spending from low income families and helping small and medium-sized enterprises (SMEs), which suffer the most from the depreciating currency. Government spending is projected to increase by ¥2 trillion to 3 trillion. Monetary stimulus by the BoJ, unveiled in late October, will include more purchases of Japanese government bonds and a tripling of its purchases of Japanese stocks. Required equity allocations by government-controlled Japanese pension funds have also been doubled.

Investment implication

While monetary stimulus has effectively weakened the yen and bolstered the Japanese stock market, Shinzo Abe and the Bank of Japan face a difficult balancing act between stimulating growth in the economy and moderating the amount of government debt. In the short term, Abe’s decision to postpone the consumption tax hike is positive for an economy that confronts weak growth and persistently low inflation. In the longer term, further fiscal and structural reforms will be needed to combat poor underlying economics. We take a slightly positive view on Japanese equities given the short-term upside potential from further stimulus, but many more reforms must occur to fix long-term fiscal and structural trends.

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