The Road Not Taken

By Harry Hill, Hottinger Investment Management

“Two roads diverged in a wood and I –

I took the one less travelled by,

And that has made all the difference.”

– Robert Frost

In a somewhat similar dilemma to the one described by Robert Frost, most investors have taken one of two possible paths. Some believe we are mid-cycle and some believe that we are walking into a recession. In this instance, we did not take the road less travelled by, and fall into the latter camp.

The global outlook is broadly consistent; falling PMIs, low unemployment, slowing earnings growth and an over-reliance on a robust consumer. Although similar, Japan paints a new picture as concerns over consumer weakness take effect. Despite this backdrop, the Nikkei 225 was up 6.14% in September. Should this move represent the investors that took the road “less travelled by”, with the belief the global economy is still mid cycle, a closer look at the fundamentals in Japan now may help investors decide which road to take.  

Manufacturing sentiment in Japan has fallen to its lowest levels since 2011, a level last seen when the country was recovering from the Great East Japan Earthquake. In August, industrial production in Japan fell 4.7% from a year earlier, marking it as the 8th time in the last 12 months that production has fallen (according to Deloitte). The outlook for export growth remains ominous with Capital Economics forecasting a 2.7% drop in export volumes next year, following a 1.5% drop this year. Although significant, the fall in Japan’s PMI was in tandem with that of the US and eurozone, suggesting that this change represents a broader decline in the industrial sector and is largely a result of the US-China trade dispute.    

On October 1st, the Japanese government hiked the national sales tax from 8% to 10% in the latest of their efforts to stimulate the economy. The additional tax revenue should allow the government to fund social welfare programmes – such as pre-school education – as a means to improve labour force participation, and pay down its large public debt. The problems with this are twofold. In the preceding months, consumers front-loaded purchases in an effort to take advantage of the lower tax rate. In August, retail sales were up 4.8%, the sharpest increase since 2014, yet relatively small when compared to the similar rallies ahead of the tax hikes in 1997 and 2014. Given this move, it is more likely that households will consume less in the months to come and so we question the likelihood of improved tax revenues through this policy. With the forecasted decline in consumer spending and the current reliance on the consumer to drive economic growth, the outlook is dim.

Looking to unemployment, which further dropped to 2.2% in July – its lowest level since 1992 – whilst encouraging, it is a deceptive picture. As global growth slows, with weaker foreign and domestic demand, Japanese firms will be more reluctant to hire new workers. As such, Capital Economics is forecasting a rise in the level of unemployment to 2.7% by the end of 2020, with knock-on effects for wage inflation and consumers purchasing power.

Due to lack of demand, bank lending across the major regional banks slowed, with bank deposits growing at a greater pace than bank loans. With mounting concerns over the health of Japanese banks, it is unlikely that the Bank of Japan (BoJ) will cut its short-term policy rate. In a renewed effort to stimulate the economy, the BoJ will likely shift focus from the purchase of long-term government bonds to short-term bonds to steepen the yield curve. Fiscal spending, although already elevated, has received a generous budget for the current fiscal year with a 1.3% increase in public spending and expectations of further increases in 2020. Overall, though, it is questionable whether this is enough.

Despite the bleak macro outlook, September’s markets told a different story. The 6.14% gain in the Nikkei 225, its biggest monthly gain in 8 months, trumped the 1.17% return on the S&P500 over the same period, suggesting investors are pricing in a lower likelihood of recession. There are renewed expectations for the FED to ease policy and increased optimism for a trade agreement between China and the US. The Japanese 10-year government bond yield rose 0.12% but less than the US 10-year, which rose 0.17%. The Yen depreciated from $106 to $108 and gold fell 2.98% to $1,481.49. The question is whether this represents a rational move in markets or a minority walking down the road less travelled?