Why Japanese equities are still on an upside, but risks abound

Market Realist

Watch the wages

The Bank of Japan has made a lot of changes in its economy over the last year. The central bank has had several false starts over the last 20 years, but this latest foray into quantitative easing could finally jumpstart a perpetually stalled economy. The key metric to watch is wage inflation, as this figure isn’t distorted by food and energy prices and would drive increases in consumption.

Japan is no longer facing deflation, as the BOJ’s pledge to double the money supply to achieve its 2% inflation target has been taken seriously by the market. The WisdomTree Japan Hedged Equity ETF (DXJ) has gained 55% in the last year. Going forward, it looks like the BOJ will have to accelerate its money supply growth in order to keep the recovery on pace and hit its target.

Lack of wage inflation is concerning

Prime Minister Shinzo Abe has been trying to negotiate with business leaders to increase wages over the last couple months. This sort of politicizing is concerning because it appears that Japan’s government thinks it can force the economy to hit its desired targets though uneconomic actions. Actions like this are reminiscent of price ceilings in Latin American countries and other failed price setting policies initiated by governments who chose to defy basic economic theory.

The question then is: what will the BOJ do next? The two most likely scenarios are that it accelerates asset purchases or continues at the current rate. If asset purchases continue at the current rate, inflation will likely roll off on a year-over-year basis and Japanese stocks will fall. If they accelerate, the equity market could see another leg up and be a lead performer once again in 2014.

Remember, the Nikkei is still nearly 20% below its 2007 peak.

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