Investor optimism that Japan is finally moving from a long-running debt-deflation spiral to a ‘virtuous’ inflation cycle has pushed its stock market to record highs.
An expected macroeconomic shift from deflation to inflation, improved company earnings and corporate governance reforms (such as increasing the number of independent board members and greater shareholder advocacy) have brightened the outlook for Japan’s stock market since late 2023.
The Japanese yen’s sharp depreciation due to the diverging monetary policies of Japan and the US, and pessimism over China’s outlook, have encouraged investors to refocus on Japan. Monetary policy divergence has opened up a large negative interest rate differential, causing the yen to fall sharply against the US dollar and adding to imported inflation in Japan since 2022.
Japan had been mired in deflation for three decades. This saw nominal GDP growth fall from an annual average of 5.4% in the 1980s to 1.9% in the 1990s and then to -0.4% in the 2000s.
However, nominal growth started to rise after 2012, averaging 1.4% a year between 2012 and 2019 and rising to 3.1% between 2021 and 2023.
The Bank of Japan’s (BoJ) negative interest rate policy created a large gap between Japan’s real interest rate (‘r ‘ in Exhibit 2 below) and the rate of real GDP growth (‘g’): it averaged over -400bp in 2022 and 2023. The gap is significantly wider than the -200bp gap that experience suggests is needed to sustain economic growth in a debt-deflation environment.[1]
The (r-g) gap matters
A large and sustained (r-g) gap is crucial to rekindle ‘animal spirits’ and revive private sector spending to help reflate the economy.
BoJ research shows that Japanese companies and households have responded to the stimulative effects of its persistent ultra-easy policy by changing their pricing habits. Companies are abandoning their reluctance to change prices and lift wages, while unions and workers have begun to ask for – and are actually getting – pay increases.
Notably, Japan’s biggest labour union group Rengo successfully negotiated a pay rise of 5.3% in March 2024 (up from 3.8% in March 2023). The increase was significantly above market expectation of 4.0% and it had not been seen for over 30 years.
The market now expects the ‘Shunto’ annual wage negotiation round between workers and employers to set into motion a cycle of higher wages, which should stimulate consumer spending, lift prices sustainably and help pull Japan out of a decades-long economic morass.
Structural factors boosting Japan’s wages
Other recent research has refocused attention on Japan’s labour shortage, which is putting upward pressure on wage growth. While the prime working age population has continued to rise, mainly due to the greater participation of female and older workers, the limits are in sight. More than half of the female labour force is working and, crucially, the older age participation rate, which rose from 20% in 2010 to 26% in 2021, is now stagnating (see Exhibit 3).
There is evidence that occupational mobility is rising. As approximated by the combined rate of workers joining and leaving their companies, labour mobility rose to a post-Covid high of 4.21% in January 2024, above the five-year average of 3.8% (see Exhibit 4). This should facilitate negotiations for higher pay.
Japan’s demographic problem of a shrinking labour supply limiting GDP growth has been well-known. However, financial markets have recently taken to viewing this long-term negative structural factor as a short-term positive bet on the revival of a wage-price spiral. Markets expect Japanese companies to pass on the higher labour cost to selling prices, thus improving the earnings outlook.
What will sustain Japan’s turnaround?
For Japan to emerge from the debt-deflation squeeze, the rise in wages would need to be translated into greater consumption rather than higher household savings or debt-reduction. Companies would need to pass on the higher labour costs to selling prices. This would prompt workers to negotiate more pay increases, setting off a wage-price spiral which would reflate the economy sustainably.
BoJ policy would need to remain accommodative to keep the (r – g) gap wide at -200bp or more and prevent economic growth momentum from faltering. Despite the BoJ’s recent exit from its long-running ultra-easy policy, it would need to keep real interest rates in negative territory to revive the dynamism of the corporate sector and boost capital expenditure to lift productivity and sustain nominal GDP growth.
The prospect of these developments helps explain the recent investor optimism on Japan. Time will tell if things unfold as expected.
[1] For example, see “Debt Sustainability: r-g Is Key”, Global and US Economics, Morgan Stanley, July 14, 2021.
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