WisdomTree Research

MARKET INSIGHTS [ December 2015 ]

2016: Ten Surprises for Japan

BY JESPER KOLL
It is the time of year when economists and strategists present their forecasts and baseline scenarios for the year ahead, 2016.
Quantitative forecasts are based on de facto probability models, and qualitative scenarios are based on, well, a combination of
experience and common sense. Either way, most methodologies leave little room for a discussion of true outliers and surprises.
This list of 2016: 10 Surprises for Japan is trying to address this deficiency. Here are the out of consensus scenarios that I
personally worry about as possible inflection points for Japanese investment strategy. By definition, they carry probabilities that
may be one or two standard deviations1 away from the markets baseline assumptions; however improbable today, any movement
toward their far-out targets may well trigger major inflections in Japanese markets. Their primary purpose is to stimulate the reader
to watch out for the unthinkable.
Enjoy and best wishes for a healthy, happy and prosperous 2016.

1) 4% NOMINAL GROSS DOMESTIC PRODUCT (GDP) GROWTH

Nobody expects high growth in Japan. Most forecasters doubt Prime Minister Shinzo Abes target to push up GDP from the
current 500 trillion to 600 trillion can be achieved in the foreseeable future. Abe benchmarks around 3% nominal GDP growth per
annum, but by the end of 2015, the consensus forecasts not even half that rate of growth for 2016. So a growth spurt with nominal
GDP surging to a 4% run rate by mid-2016 would come as a real surprise.
Possible? I would not rule it out. Take the combination of added fiscal boost, a slingshot start on capital investment, plus pent-up
demand from retail consumers, and you could quickly end up with a domestic economy firing on all cylinders in early 2016. True, in
2015 neither tight labor markets nor record corporate cash balances ended up feeding demand, but in turn, the austerity and cash
hording of 2015 may very well have increased the de facto purchasing power for a 2016 demand surge.
For equity markets, a Japanese growth spurt would be a positive surprise, with neither the domestic nor global investor positioned
for it, in our view. Yet the real surprise may come from the Japanese government bond2 (JGB) market: It is unlikely that 4% nominal
GDP growth can work together with 10-year bond yields stable below 0.5%. That would be a really surprising consequence of a
Japanese growth spurt surprise.

Standard deviation: measure of how widely an investment or investment strategys returns move relative to its average returns for an observed period. A higher
value implies more risk, in that there is more of a chance the actual return observed is farther away from the average return.
2
Japanese Government Bond (JGB): A bond issued by the government of Japan. The government pays interest on the bond until the maturity date. At the maturity
date, the full price of the bond is returned to the bondholder. Japanese government bonds play a key role in the financial securities market in Japan.
1

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2) JAPANS CURRENT ACCOUNT3 DEFICIT RETURNS

2015 brought the return of trade and current account surpluses to Japan. With energy prices low, some nuclear reactors back on
line and exports stable to modestly growing, the consensus appears to expect a further expansion of this trend. A drop back into a
balance-of-payments deficit would come as a surprise, with possibly big implication for a weaker yen.
Possible? Exports are driven by global growth in general, U.S. car sales in particular. Here, not only is the U.S. car cycle already very
late stage, but the relative market-share gains for Japanese makers at the end of 2015 appear largely due to a drop-off in sales from
the major German competitor. This may well turn out to be just a temporary plus for exports; no doubt, the Germans will fight back
in 2016, and the euro currency weakness is poised to translate into powerful ammunition to create price competition advantages for
German makers before long. Meanwhile, Japans import bill could also be under more upward pressure than expected: If domestic
demand starts to increase, the decade-long structural shift toward offshore production for many Japanese capital and consumer
goods companies should trigger much faster import demand pull than observed during previous cycles. Japans aggressive
offshoring is poised to have raised the import elasticity substantially, which in turn raises the probability of higher imports forcing
trade and current account deficits as domestic demand recovers. Add to this the growing possibility of a reversal in the terms of
trade as the 2015 drop in energy and commodity prices begins to fade from year-over-year comparisons.
If a Japanese trade or current account deficit comes back into sight, the case for yen depreciation is poised to get stronger, with or
without added stimulus from the Bank of Japan (BOJ).

3) WAVE OF JAPANESE FINANCIAL COMPANY MERGERS

Japanese finance is under pressure to develop a fundamentally new business model. Pressure is building from all sides: The unwinding
of cross-shareholding directly undermines the traditional main-bank relationships; the demographic destiny of regional economies is
eroding future business development for regional financial services providers; there is increasing competition from the privatization
of Japan Post; and on the macro side, the shift from deflation to inflation is bound to drive a shift away from deposit-based finance
toward direct finance. Many forward-looking dynamics suggest that Japans financial system is overbanked, overbrokered and
overinsured. A real surprise would be if 2016 marks the start of a broad-based and deep-rooted wave of consolidationnot just
among regional banks, but cutting all the way into megabanks, major investment banks, asset managers and insurers.
Possible? I am convinced that a consolidation wave will come sooner or later, but one key force delaying it maybe the lack of
clarity on the future global regulatory framework for universal banks and integrated financial services providers. Still, even with this
lingering uncertainty, a roll-up merger wave among regional banks is most likely to accelerate and, in my personal view, I would not
be surprised to see some of the megabanks beginning to increase their nationwide reach by buying more local players.
If the visibility of a financial services consolidation wave rises in Japan, the market implication could be that Japans financial sector
moves toward becoming a top-performing sector for 2016, in my personal view.

Current account: The difference between a nations total exports of goods, services and transfers, and its total imports of them.

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4) A JAPANESE HACKER BREAKS THE GLOBAL CYBERTERROR NETWORKS

The war in cyberspace is real, with cyberattacks on corporate, private and public networks now the biggest known unknown challenge
for risk managers and leaders everywhere. So far, Japan appears as a relative latecomer to cyberwar prevention and countermeasure
development, but this started changing in 2015 with both public policy and private initiatives beginning to focus on the problem. A
real surprise would be if a team of Japanese hackers cracks a key code of cyberterror and develops a credible early-warning system
that can predict or even stifle future attacks.
Possible? While few engineers or investors doubt Japans prominence in robotics, the real-world reputation of Japanese software
developers and hackers is much in need of a big showcase win. A global breakthrough coming from Japan would be a real surprise. It
would, however, almost certainly raise the ambition and popularity of Japanese youth to pursue more software and IT-related careers.

5) PM ABE CALLS DOUBLE ELECTIONS AND WINS BY A LANDSLIDE

In July 2016, one-half of Japans upper house of parliament is due to stand for election. Unlike the fixed-cycle election rule for the
upper house, Japans lower house election cycle rests de facto in the hands of the prime minister. He can call an election whenever he
deems most opportune. Prime Minister Abe won a landslide two-thirds majority at the end of 2014. For 2016, a big surprise would be
if he dissolves the lower house and calls a double election. Conventional wisdom argues against taking this risk, and Abe himself
recently suggested he is not currently thinking this way. What would change his mind?
Tactically, the more the economy recovers and creates a real feel-good factor, the more likely a snap election becomes. A key
indicator could be a surge back toward 60% in Abes popularity (currently around 45% to 50%). Note here that Japan will host the
2016 G-7 Summit meeting May 2627, which could well boost Abes popularity and reputation as a global leader in the eyes of the
Japanese people. Strategically, Abe may be tempted to go for a double because the opposition parties remain in disarray and
without funding. He may also want to get the election out of the way before the next hike in the consumption tax, slated for April 2017.
In our view, a double election would be a surprise, but if it happens it would probably be good news for markets. We think so
because we are convinced that Team Abe will only call an election if the probability of a major landslide victory in both the lower
and upper house is very high indeed.

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6) MINISTRY OF FINANCE (MOF) AND BOJ AGREE TO RESTRUCTURE JGBS INTO ZERO-COUPON PERPETUAL BONDS
The Bank of Japan is mopping up government debt like few other central banks have done in history. Is there an exit? What is
the endgame? Over the coming months, the Federal Reserves first concrete moves away from quantitative easing4 may prove
valuable lessons for what the BOJ will have to face eventually. A real surprise would be if Japanese technocrats decide to pre-empt
this debate and propose a more proactive course for Japan. If both MoF and BOJ agree to restructure the BOJ-owned JGBs into
zero-coupon perpetual bonds, the Japanese fiscal-monetary nexus could keep running without markets having to worry about
the eventual exit.
Possible? Surely it would be a very radical step with little historic precedent. However, if, against expectations, the Feds balance
sheet normalization causes greater-than-expected financial disturbances, a more pragmatic cooperative approach between the
treasury and the central bank could well become possible in Japan, in our view.
If so, the implications for the bond market maybe less significant than the possible impact on the currency: Yen currency devaluation
risks would rise significantly, in our view.

7) ABENOMICS5 WINS THE NOBEL PRIZE FOR APPLIED ECONOMICS

This, of course, would be an incredible surprise. There simply is no such thing as a Nobel Prize in applied economics. Academics
get rewarded, not practitioners. Still, my point is that, at the end of 2015, few commentators and strategists believe Abenomics
will be successful. For 2016, a surprise would be a reversal of this. In media commentary, this would be reflected in increasingly
positive commentary on how Abenomics is working and how it could become a model for other countries leaders of economic
policy. Could the G-7 Summit hosted by Japan in May be the launchpad for such a campaign?
In Japans equity markets, this would be reflected in the development of an Abenomics premium (i.e., price-to-earnings
multiple expansion).
Possible? In our view, global opinion leaders still very much underappreciate the pro-business policy drive and expert coordination
of all levers of policymonetary, fiscal and regulatory. Both global and domestic investors are still structurally under-weight
Japanese risk assets, in our view. Add to this the increasing credibility of Abe-led private and public sector partnership, and you
end up with a strong case that, yes, Abenomics may very well turn out to be the most impactful and far-reaching structural growth
policy program in place in any of the advanced industrial economies in todays real-world free-market parliamentary capitalism.

Quantitative Easing (QE): A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the
market. Quantitative easing increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity.
5
Abenomics: Series of policies enacted after the election of Japanese Prime Minister Shinzo Abe on December 16, 2012 aimed at stimulating Japans economic growth.
4

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8) U.S.CHINA POLICY COORDINATION

The U.S. dollar remains the global anchor currency and, as the Federal Reserve (Fed) begins to hike U.S. interest rates, the de
facto impact will be a tightening of financial conditions for many emerging market economies. The risks of U.S. rate hikes deflating
global growth are of significant concern for many forecasters, including the International Monetary Fund and the World Bank.
Nobody is forecasting an offsetting counter-policy response. So it would come as a real surprise if the Peoples Republic of China
were to step in and present a sizable fiscal expansion program. In many ways, a Chinese fiscal demand boost would be a most
credible global insurance policy against the negative impact of higher U.S. rates. Almost certainly, it would translate quickly into
higher demand for many of the emerging economies exports.
Possible? During the Lehman shock crisis, China did indeed answer the need for global demand stimulus with a massive
Keynesian-style stimulus that helped turn the crisis-induced downturn into the next upturn. Whether at this point in the cycle China
could be counted upon is not clear. However, 2015 brought the China-led establishment of the Asian Infrastructure Investment
Bank. It is highly probable that 2016 will bring the first concrete positive demand-pull projects coordinated by this new pro-growth
institution. So even without open U.S.-China policy coordination, the de facto policy drive led by China could lead to positive
growth surprises in 201617, particularly for Asian emerging markets, in our view.

9) TRANS-PACIFIC PARTNERSHIP (TPP) GETS BLOCKED BY U.S. POLITICAL INFIGHTING

The impact of the Trans-Pacific Partnership free-trade agreement on Japans economy is broad-based and deep. It ranges from
tariff cuts on agriculture to intellectual property protection and protection against unfair competition from state-owned enterprises.
Full implementation is, in our view, one of the important change agents toward greater productivity and a higher potential growth
for Japan. A surprise, if not a shock, would be if U.S. lawmakers block the TPP from coming into law. On top of the potential
negative impact on Japan, the bigger negative surprise would be possibly irreparable damage to Americas leadership credentials
in Asia-Pacific, in our view.

10) A JAPANESE MEDAL IN THE 100M OR 200M OLYMPIC SPRINT

2016 will bring the next Summer Olympics. Japan has plenty of sports talents but has never done well in track and field events in
general, short-distance sprinting in particular. However, change is afoot. A real surprise could be Japans youth sprinting sensation
Abdul Hakim Sani-Brown-san winning a medal in Rio. Born in Fukuoka to a Japanese mother and a Ghanaian father, the 16-year-old
broke Usain Bolts longstanding 200-meter world youth record in 2015.
Possible? This upcoming Olympics is definitely an aggressive call for a 17-year-old boy to become the worlds fastest man. However,
I am very confident all this means is that my prediction is just a little too early. At the Tokyo Olympics in 2020, Japans sprint ace
Sami-Brown-san will be right up there in the center of the medal podiumand that is a forecast, not a surprise.

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Unless otherwise stated, data source is WisdomTree..

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