Japan Update

Japan’s Prime Minister Yoshihide Suga unexpectedly announced his resignation on 3 September, sending the yen down and Japanese equities up more than 2% to a 30-year high, as markets bet on a big fiscal stimulus from his successor.

Despite the positive market reaction, we note that Mr Suga’s decision replaces one form of political uncertainty with another, including the possible return to revolving-door premierships that used to be synonymous with Japanese politics. Mr Suga will continue as Prime Minister until the leadership race within his ruling party the LDP, scheduled for 29 September. This will be followed by a parliamentary election, currently scheduled for October and which must be held by 28 November.

The race to succeed Mr Suga is wide open. At least two candidates are strong contenders who are expected to make their candidacies official soon: Kono Taro (a former foreign minister and current vaccination czar) and Kishida Fumio (a former foreign minister). Former government minister Takaichi Sanae has also declared her candidature. A return to the ring from former premier Shinzo Abe, while possible, looks unlikely. Mr Kono looks to be the frontrunner, given his name recognition and popularity.

Yet even with a new – and potentially charismatic – leader, the LDP will likely see a much-eroded majority in the upcoming elections, given voter fatigue and better coordination between leftist opposition parties. This introduces more political instability in the medium term, with the risk of bureaucratic inertia and an erosion of policymaking clout for Prime Minister’s office over time. While unlikely, a win for the opposition would be considered outright market negative.

Instead, markets have chosen to focus on a possible new fiscal stimulus announcement from Japan’s next leader. Japan’s economy contracted in the first quarter and has been hampered by a slow vaccination roll-out and new waves of infections. Unlike many large economies, it has yet to return to pre-pandemic levels. Should the LDP retain its majority in the lower house, it will attempt to pivot quickly to pandemic management and economic boost with a new year-end supplementary budget.

We have been cautious on Japanese equities so far this year, given extended valuations, political instability, slowing Chinese growth momentum, and Covid spikes putting many regions into a state of emergency. Thus far, our view looks to have been justified, with Japanese equities underperforming in USD terms by 13% year-to-date, even after the recent rally. The yen slipped below USD110 against the dollar on Mr Suga’s resignation; we foresee it settling around the 109 level, without any major catalyst for a big move in either direction. Even after Friday’s announcement, a degree of caution is still merited.

That said, we certainly believe the situation now looks more balanced. Growth is rebounding and the vaccination pace is now impressive. Fiscal stimulus could provide a huge boost, as well as helping assuage voter discontent on the handling of the pandemic.?We are monitoring the evolving political situation, as well as any potential stimulus announcements, carefully.

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