Japanese equities have underperformed the US and emerging markets in common currency terms so far in 2016, while faring slightly better than UK and continental European stocks. Monetary trends and demand / supply considerations suggest that relative performance will improve.
GDP rose by just 0.05% in the second quarter but this may represent payback for a 0.5% first-quarter gain, which may have been flattered by a statistical leap-year effect. Two-quarter growth moved up to 0.55%, or 1.1% at an annualised rate, the fastest since the second quarter of 2015. Monetary trends are signalling a further rise, with six-month growth of real narrow money M1 surging since the Bank of Japan (BoJ) introduced a negative rate on the top tier of bank reserves in February, and real M2 / M3 expansion also firming – see first chart.
Faster growth of M1 than broader aggregates normally signals that companies and consumers are shifting their monetary savings into more liquid form ahead of boosting their spending. A similar divergence occurred in the Eurozone after the ECB cut the deposit rate to negative in June 2014 and was followed by significantly stronger domestic demand and GDP growth in 2015. (As an aside, a recent claim that the current wide gap between M1 and M2 growth in China is evidence of a “liquidity trap” and has negative economic implications has no basis in monetary theory and is not supported by international historical evidence.)
Six-month growth of real narrow money is now higher in Japan than in most other developed economies, suggesting greater potential for a positive economic surprise, which could boost relative equity market performance – second chart.
The demand / supply backdrop, meanwhile, appears favourable. The BoJ has been buying at a weekly average rate of ¥69 billion over the latest three months but last month’s decision to raise the annual target for equity ETF purchases from ¥3.3 trillion to ¥6.0 trillion implies a step-up to ¥115 billion – third chart. ¥6.0 trillion is equivalent to 1.9% of the market capitalisation of the TOPIX index (free float basis).
Business corporations, meanwhile, have been buying shares at a weekly rate of ¥51 billion over the latest three months, while issuance averaged only ¥19 billion a week in the three months to July.
There is additional “structural” demand from the Government Pension Investment Fund (GPIF) and other public schemes. The GPIF’s weighting in domestic equities stood at 23.35% at end-December, the latest available date, versus its target range of 25% plus or minus 9 percentage points. Public pension funds in aggregate bought equities at a weekly rate of ¥74 billion in the first quarter, according to the BoJ’s flow of funds accounts.
The combination of BoJ QE demand, corporate float shrinkage and public fund buying suggests upward pressure on prices unless foreign investors or individuals dump shares. Foreigners, however, have reduced exposure significantly since May 2015 and may be underweight, in aggregate, relative to benchmarks. They may be forced to buy if the market starts to outperform.
Individuals tend to accommodate swings in foreign demand but they may be reluctant to sell at current prices owing to a lack of appealing alternatives, with government bond yields negative but rising, and foreign investments at risk from further yen strength.
The suggestion is that higher prices will be required to balance the net demands of the various sectors.