Japanese equities have suffered significant volatility in 2016, borne of uncertainty in both the domestic and overseas economies. The extension of extraordinary measures from the Bank of Japan and from the European Central Bank are clear indications that despite the unprecedented support delivered since the financial crisis global economies remain fragile. In the case of Japan, there is a lack of clarity on three major fronts at the current time: monetary policy, fiscal policy and corporate earnings.

The Bank of Japan’s decision to add negative interest rates to their policy of quantitative and qualitative easing surprised markets in January. The key objective of stimulating inflation remains one that will take time to evaluate but the central bank will have also wanted to see the yen weaken and the equity market strengthen. 

The initial market reaction in line with these hopes was quickly reversed and further mixed economic data since the January meeting will have added to discomfort among policymakers. The uncertainty around whether the BoJ will ease monetary policy again, when this might happen and what form it will take is further clouded by concerns about how much more it can do, the appearance of diminishing returns from additional easing and also the, at times, contradictory words and actions of Governor Haruhiko Kuroda.

With monetary policy losing some of its potency, market hopes have moved further towards a fiscal response from Prime Minister Shinzo Abe's government, but here too there are a number of moving parts. Putting aside Japan’s indebtedness, Prime Minister Abe has a July election to focus on and the weak economic environment undermines his "Abenomics" project of economic reform. Consequently a well-timed and substantial supplementary budget may boost the government’s chances of securing a significant victory in the Upper House election. 

With an eye on the longer term, the government could also call a Lower House election and the justification could be a further delay to the consumption tax increase currently planned for April 2017. Such a postponement would likely be well received by the Japanese public and could support economic recovery, enhancing the government’s chances of extending their period in power; it would also capitalise on the opposition party’s continued lack of cohesion. Whether these are gambles Prime Minister Abe is willing to take remains the subject of much speculation and, for now, equals amounts of ambiguity.

Corporate earnings in Japan have been strong over recent years, but some of the main supports have started to fade, suggesting that further earnings growth in the fiscal year to the end of March 2017 (FY3/17) may be tough to achieve. Corporate Japan has benefited from a sharply weaker currency and healthy overseas demand. More recently the yen has been strengthening, despite the additional easing from the central bank, and the support of overseas demand is now less clear.

Data from Mitsubishi UFJ Morgan Stanley shows Japanese corporate earnings in the third quarter of the current fiscal year slowed significantly, ending flat year-on-year, with pre-tax profit growth forecasts for the fiscal year as a whole now around 5 per cent, having been close to 10 per cent at the end of the first half. With the currency stronger, overseas economies subdued and companies naturally conservative in setting targets, it is unlikely that forecasts for FY3/17 will provide a new source of support.
 
Looking overseas, Japan remains an economy that is sensitive to global conditions. The US has been the major bright spot for the global economy for some time, but even here the outlook is not clear. The extent of monetary policy tightening has become more opaque, with market projections at odds with the US Federal Reserve’s suggestion that interest rates would be hiked four times in 2016.

In Europe the scale of the ECB’s most recent monetary easing provides an obvious indication that the continent’s economy remains in need of extra support to achieve sustainable growth and inflation. China too has been easing monetary policy and the process of rebalancing the economy is one that inevitably involves some turbulence. Other important Asian economies have suffered from commodity price weakness and slower economic output and as major trading partners of Japan this has dampened the prospects for the Japanese export sector.

Longer term, I believe the Japanese equity market continues to offer investment opportunity, based on reasonable valuations and ongoing reform of corporate governance. Last year saw record levels of share buybacks, which rose 52 per cent year-on-year to Y4.8 trillion ($422 billion), according to figures from Goldman Sachs, while a number of companies have reacted to recent share price falls by announcing new repurchase plans.

In the short term, challenges from a stronger currency and a weaker external environment are likely to dominate and in a potentially tough year for profit growth we continue to focus on areas of the market where we can find modest valuations and earnings visibility, notably in real estate, retail and electric power companies.