Chetan Ahya: A Bullish Outlook on Japan

The first of our three-part series on the Japanese economy dives into the three key factors that have triggered a recent surge in interest from investors.

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Welcome to Thoughts on the Market. I'm Chetan Ahya, Morgan Stanley's Chief Asia Economist. Along with my colleagues bringing you a variety of perspectives, I'm kicking off a special three part episode on our outlook for Japan. Today I'll be discussing our view on the Japanese economy. It's Wednesday, July 19th at 9am in Hong Kong. 

As you may have seen, Japan's economy and financial markets have attracted outsized investor interest this year. We at Morgan Stanley Research have had a constructive view on the macro and markets outlook for some time, based on three pillars: A decisive shift away from deflation, structural macro reforms coupled with the improved corporate governance on the macro front and return on equity for the corporate sector. 

Let's start with the macro outlook. From my vantage point, the single most important factor that defines the Japan narrative is inflation. Between 1993 and 2012, the Japan economy was trapped in deflation, with headline inflation hovering around 0%. The pursuit of Abenomics from 2013 onwards brought about a transition from deflation to low-flation and inflation managed to move a tad bit higher to an average of 0.5% from 2013 to 2019. In this cycle, we are seeing yet another shift in which Japan is decisively exiting deflation. Indeed, we see Japan transitioning into moderate inflation territory, where inflation averages 1 to 1.5% over the medium term. 

How is this inflation outcome achieved? Since the early 1990's, Japan has experienced monetary easing and fiscal easing, but the two have never really come together in a coordinated fashion, and in fact at times have neutralized each other. This started to change in 2013, when fiscal easing was combined with quantitative and qualitative monetary easing, which we think was critical to initial exit from deflation. 

In this cycle, we finally saw wage growth rising to a multi-year high, which in our view is the final key ingredient that will sustain inflation in the range of 1 to 1 and a half percent. Moreover, we don't expect a premature withdrawal of accommodative macro policies. Against this backdrop, we believe inflation expectation will be re-anchored to a higher level than before. 

Why is the liftoff of inflation so important? Well, moderate inflation is what makes the economic machine work. If consumers expect deflation or low-flation, they will be incentivized to put off their spending plans. For the corporate sector, the resulting high level of real interest rates will not catalyze new investment. This whole situation changes when moderate inflation takes hold and inflation expectations shift. Animal spirits come back to life, and that is at the heart of why we are bullish on Japan. 

In the next episode, we are going to continue this conversation with our two leading minds on Japan, our Chief Japan Economist Takashi Yamaguchi, and Japan Senior Advisor Robert Feldman. The three of us will dive into the implications of the shift in Japan's nominal GDP path, the outlook for BOJ's policy, as well as the outlook for structural reforms. And to wrap up the series, I'll speak with our Equity Strategist Daniel Blake about our market outlook and what investors should focus on. 

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