After more than two decades of growth-crushing deflation, Japan is on course to celebrate its first bout of inflation sometime next year; and investors would be well advised to begin positioning to benefit from its arrival.
Unlike previous episodes in which Japanese economists prematurely (and erroneously) hailed inflation’s imminent return, we think the conditions are now ripe for its long-awaited homecoming.
The country’s output gap (domestic demand less supply capacity) is positive again for only the fourth time in 20 years. The wages of part-time workers are growing 2–3 percent a year, the sharpest rise since 2005, and we think overall wages will increase 1 percent y/y from 2017 to 2018 (vs. close to zero over the last 20 years) and will continue to climb steadily in the coming years thanks to the tight labor market.
These are essential drivers of inflation, but they weren’t enough to end deflation’s grip in 2006. Two factors played key roles then: the Bank of Japan (BoJ) tightened too quickly, and intensifying global manufacturing competition.
Eleven years later, the BoJ has likely learned its lesson; we expect it to keep its policy accommodative to support growth until inflation reaches a sustainable 2 percent rate. Meanwhile, the pressure on Japanese manufacturers has waned considerably in recent years, alleviating the need to cut prices to remain competitive.
We think Japan’s inflation rate will hit 1 percent y/y within the next 12 months (from 0.5 percent y/y currently). But considering the country’s deflationary woes and mistaken forecasts over the past two decades, investors are skeptical about inflation’s onset and are buying defensive stocks and those with high price-to-book values. We believe this is where investment opportunities lie.
There are three pathways open for investors who wish to gain from Japanese inflation, in our view:
1. Higher interest rates: The BoJ will likely raise the 10-year government bond rate from zero to 0.2 percent once it confirms the existence of inflation, thus lifting Japanese banks’ lending rates for the first time in 15 years. Higher lending rates should boost Japanese banks’ earnings quite significantly; our analysis shows that a 0.1 percent increase in the lending rate would boost their earnings by 8 percent on average.
2. Pricing power: Higher material prices and labor costs are negative for most companies, but those with a stronger pricing power could enjoy higher margins. Our preferred companies include some specialty retailers, electric component manufacturers and machinery makers.
3. Higher demand: Higher wages should lead to increased consumption, particularly in services such as internet- based work, education, travel, healthcare, housekeeping, and childcare services. We think the country’s wages will pick up as Japanese companies’ earnings hit record highs and the size of the working population shrinks.
In each of these segments, we prefer companies that have been under deflationary pressure and have been undervalued for a long time. Stock selection will be very different in an inflationary environment, and we believe now is a good time for investors to look at unpopular and undervalued sectors.
– Contact us at [email protected]