Our Insights

Seth Carpenter: Welcome to Thoughts on the Market. I’m Seth Carpenter, Morgan Stanley’s Global Chief Economist and Head of Macro Research. This is Part 2 of our podcast from the Japan Summit.

It’s Friday, May 22^nd at 8 am in Tokyo.

I might stick with equities for just a minute, and Sho, just to dig deeper into the equity market. Jonathan expressed some of the bullishness. Anything you want to elaborate on where the real strong conviction on this positive view about Japanese equities is coming from?

And then just as a warning, I'm going to come back to you and ask, if you're wrong, where could you be wrong? Because again, I think where we add value most to clients is not just giving a clear view, but also pressure testing that view.

Sho Nakazawa:

Our constructive view on Japan equities comes down to one simple point. Three structural changes are still continuing. So, the first is shifting macro environment. The combination of stable inflation and wage growth is a kind of phenomenon we have not seen, at least in my lifetime. It changes corporates and households’ behavior, especially in terms of balance sheet management.

And then secondly, the corporates profit improvements. We do not see it as a cyclical recovery. We see it as a structural change. As in the past, Japan corporates heavily relied on cost-cutting amid a deflationary environment. But today, price pass-through is improving, and the Japan corporates are becoming better positioned in growth profit in nominal growth environment.

The third is corporate governance reform. Awareness of the capital efficiency has clearly increased. We continue to see share buybacks, dividends increase, and a portfolio restructuring as well. And on top of that, the Takaichi administration has made growth investment and crisis management investment as well.

Of course, the Middle East situation is a source of noise. But structurally is a supporting factor for Japan equities secular bear market, which is a view Jonathan has held for very long time, has actually becoming stronger.

But let me say that if I'm wrong, maybe I should be more bullish. In fact, the two key drivers here, if we assess the bear case scenario on Japan equities…

So, one key driver should be the upside come from the investors constructive view on the Japan fiscal efficiency. And on a micro level, the corporate behavior changing faster than market expects. If we assess the recent rise in long-term yields, it reflect the concern to the Japan fiscal position and that BoJ behind the curve.

It would weigh on the Japan equity valuation because it raises cost of capital and it weighs on the Japan equity valuation. But on the other hand, [the] Japanese government will disclose its basic policy in June. And if it could include a credible plan to improve Japan’s fiscal positions, perhaps under Japan version of DOGE, which is led by Financial Minister Katayama-san, I think it could alleviate the excessive concern toward the Japan's fiscal position, and it [could] lower the cost of capital on Japan equities.

You know, micro level, the corporates behavior is already changing, as I mentioned. But there's still plenty, you know, space for Japan corporates to utilize non-cash generating assets such as cash and deposit, which is equivalent to 60 percent of GDP. The ratio is far higher than our global peers.

So, if Japan corporates move further to capital efficiency or portfolio restructuring or use some excess capital, I think there should be additional room for Japan equity market to re-rate higher.

Seth Carpenter: All right. So, if you're wrong, it's insufficient bullishness. That’s fair. It's a great place to be.

So, so Koichi,  Jonathan and Sho are super bullish on equities. They will be spending a bunch of their time traveling the world telling all of Morgan Stanley's clients everywhere in the world what a great buying opportunity Japanese equities are.

And so, do you expect big shift in capital flows, and would that drive further appreciation of the currency? How do you think about the global investors' view of Japan? And what it means for capital flows on the one hand, and the value of the currency on the other?

Koichi Sugisaki: As for the capital flows, I think under this fresh regime, what's the notable change among the Japanese financials? That they are shifting away from the fixed income product, I mean, like JGBs.

Given the current attractive yields, you maybe wonder[ing] why the banking sectors buy the JGBs. But according to the recent disclosures, they have not purchased the JGBs much because their lending activity performed very well. So, as far as their lending activity have performed well, they have no incentive to make money in the securities investment.

You know, their lending activity have accelerated thanks to the corporate CapEx investment to improve the productivity amidst the labor shortages in Japan. Once the banking sector starts to see some slowdown or some symptom of the lending activity to slow down, in such a case, they are quickly shifted to the securities investment and the JGB market will change the world.

But so far, you know, lending growth [has] accelerated much. You know, the April lending growth is around 6 percent on the year-on-year basis, very strong. So, I think the banking sector still not have a[n] incentive to buy the JGBs.

As for the lifers, [the] case is much more serious, I think. Because of the younger ages shifting towards the equities to defend the asset, particularly under the new NISA scheme [which] was launched in 2024. The younger peoples basically allocate their asset to the equities rather than the saving type of the products.

Which means that the lifers are struggling to make, to gather the new monies. And this means that the demand for the long-term JGB to shrink. And the Japan lifers already filled the duration this much by 2023 to prepare for the new regulations starting from this fiscal year. Now, fortunately, they already finished the duration this much, this type of operation by 2023. But the yield [has] gone up from 2024, thanks to the BoJ's normalization.

So, under such conditions, they are now struggling to the high market loss on the long-term JGBs. And some of lifers are now facing the impairment loss accounting. That actually [makes] lifers a net seller of the long-term JGBs rather than the buyers.

Seth Carpenter: Okay, super helpful. Okay, we focused a lot on near-term developments, the energy shock, first quarter GDP. But we can think about a longer-term growth scenario. And there, I think AI comes in at times. Chetan, you've talked about the near-term super cycle, and I think there's a near-term aggregate demand side to AI, but over the longer term, maybe it's more supply.

When I think about where growth is going, though, I also think about shifts in the strategy for policy. So maybe Yamaguchi-san, you can talk to me a bit on your take of Prime Minister Takaichi's policies. What do we think is likely to get announced? When? How do you see it affecting the long-term growth outlook for Japan?

Takeshi Yamaguchi: [The] Japanese government publishes growth strategy report and the basic policy on fiscal management or honebuto policy in June every year. But I think this year's, you know, documents will be pretty important because these are the first documents under the Takaichi administration.

And these documents will set the direction of economic policy by Takaichi-san, Sanae Takaichi. Or Sanae-nomics. Compared with Abenomics, I think Takaichi-san focuses more on the supply side issues, you know, supply domestic investment. While Abenomics focused more on the exit from deflation, focusing on demand side policy, particularly, you know, monetary easing.

In the growth strategy report, the focus will be strategic investment in 17 strategic areas, including AI, especially, you know, AI robotics, semiconductors, defense and space, cybersecurity, and content industry and so on.

Another important point of Sanaeconomic system, there's overlap between these strategic investment areas and national securities. The government will also update its defense strategy by the end of this year, and there'll be a increase in the defense budget target. The focus will be a lot on, you know, I think, dual use technologies, and also resilience of supply chains going ahead.

Another important point is, I think there will be a change in the budget formation process. I think, under deflation there’s effectively cap on non-social security spending. But I think this government will likely allocate budget, you know, for multi-investment. So, I think the budget process will be more flexible. And they put more emphasis on the initial budget rather than the supplementary budget.

So, I think, these documents will be pretty important to monitor going ahead. But overall, I think, the government – yes, they do care about the market conditions. They will likely avoid massive, you know, expansion. But I think a slight expansion, especially in the area of strategic investment is likely to happen.

Seth Carpenter: Very helpful. Alright, that's the end of the panel. Thank you very much to my colleagues. And this is where I have to shift back into podcast mode to say thank you for listening. And if you enjoy Thoughts on the Market, please share it with a colleague or friend today. Thank you very much, everybody.

Seth Carpenter: Welcome to Thoughts on the Market. I'm Seth Carpenter, Morgan Stanley's Global Chief Economist and Head of Macro Research. And on today's episode, we're bringing you a live taping direct from Morgan Stanley and MUFG's Japan Summit to discuss the macroeconomic overlook. And, in particular, Japan's moment: reflation, reform, and the case for a structural re-rating.

I am joined by Chetan Ahya, our Chief Asia Economist; Takeshi Yamaguchi, our Chief Japan Economist; Jonathan Garner, our Chief Asia and EM Equity Strategist; Koichi Sugisaki, who is our Head of Japan Macro Strategy; and Sho Nakazawa, who is our Japan Equity Strategist.

Seth Carpenter: I will say we have just collectively published our mid-year outlook. So twice a year, Morgan Stanley Macro Research puts together our forecast. We take the time to debate with each other, to pressure test our views on the outlook for the next year and a half to two years.

And I have to say this version of the outlook process may have been the most difficult one that I can remember. And   in no small part because one of the key fundamental drivers of the outlook globally for growth, for inflation is oil, oil prices. And the swings there have been pretty dramatic.

And so, as a result, we put a lot of effort into not just our baseline forecast, but also scenarios and the ways in which our baseline forecast could be wrong.   

But Chetan, let me start with you.   Tell us a little bit about the exposure in Asia to, to the energy shock.

Chetan Ahya: So Seth, you're right.     Asia is one of the more exposed part of the world. But I would say that we've been surprised in the way this energy shock has been managed. One is, of course, at the global level, two big swings happened. US exports increased dramatically by 3.8 million barrels per day. Just to give you perspective, global consumption of oil is about 100 million barrels, so it's simple math in terms of how big this number was. And then China parallelly also reduced its imports by 3.5 million barrels. So, we had a 7 million barrel swing from a global oil demand balance perspective.

And, secondly, as far as gas is concerned, that is where actually we were more concerned about Asia because Asia was very dependent on Middle Eastern gas. And on that front, China single-handedly has bailed out the region. So, China cut its gas imports by about 45 percent, and that had at least avoided the shortages that we were worried about. We can manage oil prices, but shortages is something very difficult to manage .

So that's at the global level. And within the region, what every economy did is to switch to an alternative source of fuel, whether it is electricity generated through coal or other renewable sources. And particularly that happened in China and India, which are the two big importers of fuel in the region.

And then additionally, what we also saw is that everybody managed the fuel price increase quite well. So, on an average, if I look at the stats as of today, only about 25 to 30 percent of the underlying fuel price increase has been passed on to the consumer. So, the governments are taking it, so there is a burden on the fiscal front that is building up.

But as far as the consumers are concerned, this has been a help, and therefore you have not seen a big spike in inflation across the region.

Seth Carpenter:  Okay. So, a lot of comments about Asia in general. Let's go more specific to here in Japan. And so, Yamaguchi-san,  you were an early adopter of the Japan reflation view. If we go back a year, two years, three years, you were probably more optimistic, more bullish about growth in the market than consensus. More recently, you've been a little bit more cautious about where growth is going. And so,  can you tell us a little bit first why you're a bit more cautious now relative to where I suspect the market is? And then when it comes to the energy shock, how do you see it playing out with the Japanese economy? And should we worry about it derailing this whole reflation trade?

Takeshi Yamaguchi: We think Japanese underlying economic fundamentals remain resilient in the sense that, you know, nominal GDP recovery will continue as a trend. But for this year, I think there's a, you know, short-term slowdown, both in terms of real GDP growth and nominal GDP growth, due to the terms of a trade shock.

So far, you know, thanks to the government energy subsidies and Japan's relatively large strategic oil reserves, the direct impact on households has been limited. But we are already seeing a big increase in producer prices in the April data. It jumped to 4.9 percent {year-over-year], and we expect this producer price index will continue to go up due to the higher oil prices, but also because of the NAFTA-related supply side, you know, disruptions in areas, you know, such as, you know, construction materials, plastic products, and industrial solvents and so on.

That said, we still believe that, you know, underlying economic fundamentals remain resilient in the sense that there's a structural labor shortage. So, wage growth may somewhat slow, but still I think a solid, you know, base up increase will continue next year, especially among young workers. Also, I think this structural tight labor market [is] encouraging companies to step up labor-saving investment. And, I think, together with government's initiatives for domestic investment, I think, domestic CapEx will also likely remain resilient.

So, this year for nominal GDP growth, we expect, you know, slightly negative growth due to the terms of trade loss. But the next year, we are expecting above 4 percent nominal GDP growth. So, the overall, you know, story remains unchanged despite the short-term headwinds.

Seth Carpenter: Okay. So fundamental story remains unchanged. We're pretty optimistic, but it's a matter of long term versus short term  Jonathan, let me turn to you. Equity markets are generally optimistic, I would say, these days, but there is a bit of a divergence between views on equities here in Asia, between Japan on the one hand, and EM overall. In the mid-year outlook, you have expressed a preference for Japanese equities over EM.

Can you talk a little bit about that view? Why that preference? Are there sectors or specific stocks that matter more? How are you thinking about this sort of allocation across equity markets for you in Asia?

Jonathan Garner:  So, certainly, as Seth indicated and Chetan and Yamaguchi-san said, it's really an environment where the sector call, particularly the CapEx, super cycle call should drive portfolios. And that naturally leads you in Asia more to North Asia, where Japan is very richly endowed in beneficiaries of the CapEx super cycle. And obviously markets like Korea and Taiwan, and much less so to South Asia, where the larger markets are much more populated by consumer and services stocks.

So, in our portfolio, we're essentially overweight capital spending, underweight the consumer. And when you look at the Japan market, one of the things that my colleague Daniel Blake has done a lot of work is, is the sort of thematic exposures that exist within our coverage. The four core Morgan Stanley research themes of multipolar world, AI, tech diffusion, future of energy and societal shifts, they map into about 75 percent by stock number of our coverage for the Japan market, and they're quite nicely distributed across the stock coverage.

Obviously, some stocks have more than one aspect to them. And that is highly advantageous and much more advantageous than in fact any other large market. Europe of course, doesn't have AI, tech diffusion, or it largely lacks the beneficiaries, the upstream beneficiaries. The US has legacy, sort of, software service, business models and consumer exposure.

Now, it's not to say that all is sort of rosy in the garden. There are large auto OEMs here in Japan where the earnings numbers are challenged. So, it's all about the kind of the dispersion that's going on within the portfolio. But just on the base case targets, 4300 for topics, that's set by Nakazawa-san and myself. It's about 12 percent upside in the base.

In the two weeks since we published the report, EM has fallen back somewhat, so there's about 8 percent upside to our EM target. But on a kind of risk-adjusted bull-bear skew, bear in mind that EM is much more skewed in terms of the earnings drivers of that market. Essentially, if you strip Korea and Taiwan out, there's no earnings growth in EM right now. You would ultimately have to favor Japan. So, Japan should be at the core of any Asia portfolio at the moment.  

Seth Carpenter: And can you just give us a little insight as to what you're seeing about how the market is or maybe is not pricing the threat from the energy shock? What are you seeing in equity markets, top line, down into sectors? Do you think there's enough concern? Do you think there's room for that to get, sort of, rerated just on the energy shock situation?

Jonathan Garner: So, what you're seeing is that anything that is consumer-related is really struggling in terms of revisions. I think there are six different subcomponents of the consumer that we can track. Every single one of them has downgrades. And the upgrades are in energy, upstream energy, which isn't that well represented in Japan. There are a couple of names.

In materials, really across the board. In semis and IT across the board, and broadly, tech hardware. And then in the defense capital goods space. And that dispersion in revisions within the Japan market or within Asia as a whole is something that I've never seen before. 

It does maybe to some extent question the resilience of the consumer in terms of the way that the numbers are being downgraded. So, I'll just leave that hanging a little bit.

Seth Carpenter: Alright, thank you very much to my colleagues. And this is where I have to shift back into podcast mode to say thank you for listening. And if you enjoy Thoughts on the Market, please share it with a colleague or friend today. Thank you very much everybody.

Voice: That was Part 1 of a special two-part episode from Morgan Stanley and MUFG’s Japan Summit. Join us tomorrow for Part 2 of the conversation.