After fighting entrenched deflation for decades, Japan may be turning the tide, as falling unemployment pushes up wages, adding momentum to a recovery in consumer demand that could help lift economic growth, corporate profits, and stocks.
After fighting entrenched deflation for decades, Japan may be turning the tide, as falling unemployment pushes up wages, adding momentum to a recovery in consumer demand that could help lift economic growth, corporate profits, and stocks. Japan’s current unemployment rate, at 2.8%, is at its lowest in 22 years. That factor, along with above-trend GDP growth, could fuel an increase in total employee compensation by slightly more than 2% in 2017 and 2018—in line with nominal GDP growth—while growth in average hourly earnings could accelerate to around 3% in 2018, according to Morgan Stanley Chief Japan Economist Takeshi Yamaguchi, in a recent report. The seeds of the current turnaround were planted several years ago. In January of 2013, after nearly 15 years of trying to beat back deflation, Japan adopted a 2% inflation target, in line with the “three arrows” of “Abenomics”—a policy mix of monetary easing, fiscal stimulus and structural reforms that have been the hallmarks of Prime Minister Shinzo Abe’s plan to turn around the Japanese economy. Yet, despite some initial success from the central bank’s monetary easing and progress in corporate governance reforms, Japan’s inflation rate remains far below that target. Falling unemployment, however, could change all that. A tighter labor market would push companies to offer higher hourly wages to attract and retain employees, in a dynamic known as the “Philips curve, ” Yamaguchi says. Structural factors loom large. Japan is on the edge of an inexorable wave of aging baby boomers who are retiring, even as the younger working population continues to shrink. According to Yamaguchi, “There is pressure for tightening from both the demand and supply sides, as the aging population dampens labor supply, at the same time that it gives rise to labor demand for stable growth in healthcare and social welfare employment.” Cyclical factors also play a role. In 2014, a consumption-tax increase triggered a “mini recession, » from which the Japanese economy now appears to be recovering, Yamaguchi says. For corporates, rising wages can also cut the other way. Employee compensation often accounts for the largest chunk of corporate expenses, so rising wages can dent earnings, without commensurate gains on the revenue side. But Japanese firms are highly capital-intensive, and “upward pressure on wages is also associated with a stronger demand environment and higher nominal GDP growth and, hence, revenue growth, » says Yamaguchi. “We think the positives of wage inflation in Japan outweigh the negatives.» Corporates will need to adjust to the new labor-market dynamics. To combat a tightening talent market, companies must focus on improving productivity and operational efficiencies, rather than relying on cheap and plentiful labor, as some have in the past. Assuming employers can find this balance, total employee compensation should rise in line with nominal GDP growth, Yamaguchi says. Meanwhile, Garner notes that, “the best environment for equities tends to be when nominal GDP is accelerating and the wage share of GDP is stable or declining, consistent with our forecast for 2017 and 2018.» While modest wage inflation bodes well for the Japanese stock market on average, the sectors best positioned to benefit are those in which wages as a percentage of revenue are low, typically in the single to low-double digits. They include: On the other hand, logistics and healthcare names are most likely to be hurt by an increase in wages, which represent between 16% and 25% of their revenues.
