Global equity markets are on a knife-edge as we get closer to either recessionary conditions or a harmful breakout in bond yields. There are four possible outcomes for markets over the next 6-12 months. (1) Continued growth and high inflation. (2) Recession and high inflation (stagflation). (3) Recession and low inflation (most likely). (4) Continued growth and low inflation. The fourth outcome is the “goldilocks” so-called soft-landing scenario and is being increasingly discounted by global markets. A soft landing is difficult to achieve at the best of times but the likelihood of central banks engineering a soft landing after the fastest eruption in inflation and most abrupt interest rate hikes in over 40 years, seems remote. The lag time between monetary tightening and economic slowdown has been slowed down in this cycle due to the massive pandemic fiscal stimulus. In all likelihood a recession awaits. Although it should be shallow and mild given the lack of structural imbalances in the major economies, a recession will nonetheless prompt equity markets to pause.

After a brief hiatus, we expect global equities to show strong gains in 2024 and 2025, once central banks start cutting interest rates and bond yields begin to fall. In the meantime, we are taking the opportunity provided by strong markets to raise precautionary cash in portfolios. Selecting which share to sell is a hard decision as all holdings in OAM’s global portfolios are appealing, with solid upside potential. Japan offers the best candidate for raising cash and it is a good feeling to sell after a strong run rather than from a position of weakness. Japan’s Nikkei 225 is one of the best performing markets this year with an impressive year-to-date return of 27.45%.

Some analysts believe Japan is on the cusp of a new dawn, having beaten its decades long battle with deflation and with promises of improved corporate governance benefitting shareholder returns. There is also evidence to the contrary. Other analysts question Japan’s new dawn narrative. Yes, inflation is back, and companies once again have pricing power but how long will it last? In 2014 after government raised the sales tax, company revenues boomed for a brief period but then fizzled out after a couple of years and deflation returned. Current inflation is supply-side rather than demand driven and likely to be transitory as wages are not keeping up with inflation. For inflation to become self-sustaining, wages need to rise in real terms, but wage growth continues to fall short of inflation so real wages are in fact dropping.

Real household incomes are dropping in Japan faster than any other developed economy, which is showing up in the GDP figures. Japan’s GDP increased in the second quarter by an impressive 1.2% quarter-on-quarter at an annualised rate of 4.8% much faster than US growth of 2.4% over the same period, but the numbers belie a lack of momentum in household spending. Growth was driven by exports, in particular the post Covid catch-up in vehicle exports. Overall exports grew by 3.2% quarter-on-quarter, but imports fell 4.3% indicating weak consumer demand, no surprise with real wages falling for a 15th consecutive month. Private consumption, which contributes 50% of GDP fell by 0.6% on the quarter and business spending fell by 1%. The contraction in real wages worsened to 2.5% year-on-year in July.

Corporate governance has been improving in recent years but there is little to show for it in terms of financial ratios. There is scant evidence of rising profit margins or higher return on equity. New corporate governance codes allow a lot of leeway. Only a fifth of companies are fully compliant with corporate governance codes while the remainder have been permitted to opt out. According to independent research firm Capital Economics, “the improvement in corporate profitability that happened during the early years of Abenomics has run out of steam since the start of the pandemic. Profit margins of Japanese listed non-financial firms are the second lowest in the G7.”

Demographics present long-term structural impediments. The population continues to age, Japan’s fertility rate fell in 2022 to a record low of 1.26 and unlike most other mature economies there is little sign of migration to boost its working age population.

The robust year-to-date gains in the Nikkei index are attributed singularly to weakness in the yen. There is a tight correlation between the currency’s strength and the Nikkei index. Since the start of the year, the yen has weakened by over 12% against the US dollar, itself a weak currency this year. Yen weakness stems from the Bank of Japan’s monetary policy uniquely sticking to negative interest rates. The BOJ’s benchmark interest rate is pinned at -0.1% in sharp contrast with the US fed funds rate at 5.25-5.50%. The widening yield differential has caused the yen to weaken sharply against all major currencies, making exports more competitive and boosting export earnings, but the BOJ under its new governor Kazuo Ueda has begun to normalise Japan’s ultra-accommodative monetary policy, starting with the gradual abandonment of its “Yield Curve Control.” By lifting the cap on 10-year Japanese Government Bond yields, yields will rise making domestic bonds more appealing. Domestic institutions will be tempted to sell their foreign bond holdings and repatriate funds, to participate in improving domestic bond yields. The yen is expected to strengthen from its deeply undervalued levels as bond yields rise in Japan while bond yields decline in other markets led by expected interest rate cuts from the Federal Reserve.

We are reducing exposure to Japanese exposure across OAM’s global portfolios by exiting Baillie Gifford Japan Trust Plc, a long-time stalwart of our clients’ portfolios. The timing of the sale coincides with an unusually strong performance from the Nikkei index, which may be cut short by the yen’s expected appreciation. Moreover, Baillie Gifford Japan invests principally in small- to medium-sized Japanese companies, which tend to be the most resistant to change in corporate governance. The cash raised from the sale will be reallocated when the opportunity arises to US markets, which we feel offer better prospects.