By Bill Witherell, Chief Global Economist
The actions announced by the Bank of Japan (BOJ) following their two-day meeting last week fell short of the market's expectations and led some commentators to suggest the BOJ is exhausted, at the limits of the tools it has available to provide further market stimulus. We disagree. Following the announcement that Prime Minister Abe's supplementary budget is to be increased to a headline number of 28 trillion yen, the BOJ apparently was reluctant to do any more than the minimum at this time.
The BOJ's purchases of exchange-traded funds (ETFs) are to be almost doubled, from 3.3 trillion yen to about 6 trillion yen. This expansion will give welcome further support to the equity market. Also announced are a doubling of the size of the BOJ's US dollar loan program and a securities lending facility in which Japanese banks can use Japanese government securities as collateral for US dollar loans. These steps appear to be aimed at strengthening market liquidity. What surprised the markets were the decisions to leave the policy interest rate at -0.1% and to maintain the current pace of purchases of Japanese government bonds (JGBs) and Japan real estate investment trusts (J-REITs).
The BOJ's meeting on September 20-21 could well be the time for more dramatic moves. The BOJ statement concluded with the unusual pledge by Governor Kuroda to conduct a comprehensive review of the bank's monetary policy framework - the developments in economic activity and prices under quantitative easing and QE with a negative interest rate. So, both quantitative easing and the negative interest rate policy will be up for review. Kuroda will be under pressure to complement the government's fiscal policy moves by further increasing what is already the most aggressive monetary policy among the major economies. One possibility is the government's issuing 50-year bonds that the BOJ would then purchase. Former Fed Chairman Ben Bernanke's suggestion of targeting long-term interest rates is getting some attention in Japan. Kuroda will likely keep markets guessing prior to the meeting. What is clear is that the objective of any change in the policy framework will be to provide a more effective monetary stimulus to the economy.
The most recent data on the weakening Japanese economy have led BOJ board members to reduce their median real GDP growth forecast for fiscal year 2016 to 1.0% (formerly it was 1.2%). Growth in the second quarter appears to have eased from the first quarter, as the comprehensive manufacturing Purchasing Managers' Index (PMI) has been in negative territory since the latter part of the first quarter. The OECD Composite Leading Indicator for Japan is close to its lowest point since December 2012. In the Nikkei Flash Manufacturing PMI report for July, the strong yen is reported to be the reason for international demand falling at the sharpest rate in over three and a half years. Retail sales were down by 1.4% in June; average household spending similarly declined by 2.2%; and housing starts fell that month for the first time in six months. Industrial production, while recovering from May's decline, was still down 1.9% on a yearly basis.
The Abe government and Kuroda's BOJ are being pressed to respond to this subpar economic performance, and we expect they will do so. Abe now has the votes to move more aggressively. In addition to the increased fiscal outlays in the supplemental budget, Abe should now be able to carry out needed economic reforms to increase productivity and make the economy more efficient and competitive internationally. In an economy with a shrinking labor force, this is the only avenue (in the absence of increasing immigration) for raising the current low potential growth rate.
We remain bullish on the Japanese equity market. After some initial turbulence, Japanese equities rose on Friday. The largest Japanese ETF for US investors, the iShares MSCI Japan ETF (NYSEARCA:EWJ) rose by 1.77% and is up some 5.7% for the month of July. This is a healthy increase, although less than 6.4% advance for the benchmark iShares MSCI ACWI ex-US Index ETF (NASDAQ:ACWX). The strong yen, along with the market's reaction to the less-than-expected action by the BOJ, limited the advance in hedged Japan equity ETFs in July. The WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ) advanced by about 3.3%. Further substantial monetary easing in September should put downward pressure on the yen, but we have to bear in mind the continuing "safe haven" role played by the currency, as well as the fact that the exchange rate is affected by developments in the US dollar.