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October 22, 2017

Japan election: Abe's convincing win

What happened: Japanese Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP) and its coalition partners scored a convincing win that will maintain its large majority in both houses of parliament. This should extend the lifespan of "Abenomics," including the Bank of Japan's (BoJ) mega stimulus.

Potential market impacts: We see the outcome as a mild positive for Japanese equities, though recent strong performance may spark some profit taking. We're positive on Japan thanks to the synchronized global expansion that currently appears to be supporting growth, attractive valuations and solid earnings momentum. We also see the election result as a mild negative for the yen and Japanese government bonds.

Policy continuity: We don't expect major changes to fiscal or monetary policy. Although we see a less than 50-50 chance that BoJ Governor Haruhiko Kuroda stays on for a second term after his term expires in 2018, in what would be a first at the BoJ, any successor is likely to be a similar policy dove, given that inflation is stuck well short of its 2% goal. Yet we see the potential for greater uncertainty with a new governor at the BoJ's helm

Why investors should care

Market view: Japanese equities have recently begun outperforming the U.S. this year, after lagging for much of the year, rising 17.95% as of October 18th (Source: Thomson Reuters, based on MSCI Japan Index). We continue to favor Japanese equities for several reasons, including: currently attractive valuations, improved earnings outlook, and continued BoJ accommodation. The composition of the next government, therefore, has consequences for the future path of reform and BoJ policies.

Valuation of Japanese equities vs. history
and other regions

Current valuation (bars) vs. one year ago (dots)

When investors aren't fully rewarded

Sources: BlackRock Investment Institute and Thomson Reuters, September 29, 2017. Percentile ranks show valuations of assets versus their historical ranges. Example: If an asset is in the 75th percentile, this means it trades at a valuation equal to or greater than 75% of its history. Valuation percentiles are based on an aggregation of standard valuation measures versus their long-term history. Equity valuations are based on MSCI indexes and are an average of percentile ranks versus available history of earnings yield, trend real earnings, dividend yield, price to book, price to cash flow and 12-month forward earnings yield. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Implications

Potential progress on reform: The LDP was closing in on another so-called "super majority" in the lower house of parliament, giving it a stronger hand to pursue reforms. We believe the Abe government will push ahead with a planned increase in the country's sales tax but allocate the new revenue to children's education and social security spending. It may also push back the government's target for achieving a balanced budget to 2020 or later -- a potential negative for bonds that may prompt downgrades of Japan's credit rating.

We are upbeat on Japan's economy: Data point to a solid pace of growth, led by both consumption and exports, as unemployment drops to 25-year lows. Robust domestic activity and a stable-to-softer yen have spurred solid corporate earnings growth. We believe higher global bond yields have the potential to push up yields on Japanese government bonds beyond 10-year maturities.

The political picture: Abe fended off the upstart Party of Hope led by Tokyo Governor Yuriko Koike, who routed the LDP earlier this year to take over leadership of the metropolitan region. Abe’s margin of victory may help him avoid a showdown with challengers at a looming LDP leadership race due in late 2018. That will depend on how Abe's popularity rating fares in the months ahead. The new center-left Constitutional Democratic Party of Japan is on track to win more seats than the Party of Hope and become the largest opposition party, filling some of the vacuum created by the demise of the former main opposition party. Voters had turned disillusioned with Abe after scandals suggested he was growing complacent in office. But Abe's gambit of calling the election at a time when the opposition is in disarray looks to have paid off.

Japan market flows and positioning

A tale of flows: U.S. investors have had lukewarm interest in Japan this year, bucking the trend this year of flows into international equities, as the table below shows. Investors reacted negatively to the July 3rd local Tokyo election, which Koike, the leader of the new Party of Hope, won. Since then equity market positioning appears to have steadily weakened.

ETP Primary Market Flows

Equity performance and Valuations

Equity Performance

Source: Thomson Reuters as of 10/16/17. Japan represented by the MSCI Japan Index. Asia ex Japan represented by the MSCI Asia ex Japan Index. ACWI ex Japan represented by the MSCI ACWI ex Japan Index. World ex Japan represented by the MSCI World ex Japan Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

The yen story: Given the yen’s perceived safe haven status, net short positioning can help gauge market sentiment. Investors reacted negatively after the July 3 election, markets reduced the net short yen futures positioning by half from July through September (Source: Thomson Reuters as of 9/30/17). However, net short positioning has nearly doubled since the week of September 20th amid a rebound in global risk appetite, suggesting the foreign exchange (FX) markets may continue to be influenced by broader macroeconomic fundamentals and global sentiment in addition to national politics.

Bottom line: Taking increased short positioning in FX markets, which historically has accompanied increased risk appetite, it currently appears as though global markets are becoming more constructive on Japan’s outlook. However, equity outflows seem to indicate equity investors may be under-allocated.

Japanese Equities and the Yen

When investors aren't fully rewarded

Sources: BlackRock Investment Institute and Thomson Reuters, September 29, 2017. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Want to learn more? Find out why we currently favor Japanese equities.

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