How Japan’s Political Turmoil Could Spill Over Into Markets

Investors have had a muted reaction to Japan’s biggest political scandal in decades. The

iShares MSCI Japan

exchange-traded fund has dipped by 1% since Dec. 14, when Prime Minister Fumio Kishida sacked four cabinet ministers over allegations of campaign finance kickbacks. The red-hot S&P 500 gained 1% during that time. Japanese stocks remain up 15% for 2023.

Markets may need to pay more attention next year. Allegations of wrongdoing could spread and directly threaten the prime minister. “It’s even odds that Kishida will not survive this,” says Jesper Koll, Tokyo-based global ambassador for the

Monex Group

More alarming are the government’s disastrous poll numbers. Kishida, in power since October 2021, is down to a 22% approval rating, reports Yuko Nakano, who holds the Japan Chair at the Center for Strategic and International Studies. His Liberal Democratic Party is below 30% for the first time since 2012.

That reflects public disillusionment with the very “new capitalism” that has spurred fresh hope for Japan in financial markets. “The primary reason for disapproval was a lack of confidence in economic policy,” Nakano says.

Japanese politics is characterized by frequent personnel shake-ups—there have been 64 prime ministers since 1945—but steady policy based on consensus within the LDP and a powerful self-perpetuating bureaucracy.

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Groupthink remains solid on one prong of the new capitalism: eliminating negative interest rates, which have tanked the yen 20% against the dollar over the past two years. Analysts expect the

Bank of Japan

to move from negative 0.1% to zero early next year.

“The coming removal of negative interest rates is not expected to meet with much resistance,” says Shigeto Nagai, head of Japan Economics at Oxford Economics.

The second prong, shifting reflationary impetus to the fiscal side with deficit spending, is more contentious. Kishida is pushing tax cuts even as outlays rapidly increase, driven by a doubling of defense spending and increased child credits to encourage population growth. In November his cabinet passed an $87 billion supplementary budget to be doled out by March.

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Conservative bureaucrats upset by this free spending may be pushing back with the corruption allegations against government figures, Koll speculates. “It’s not a coincidence that the scandal broke after Kishida went against the ministry of finance to advocate tax cuts,” he says.

Whatever the underlying machinations, young Japanese are literally not buying Kishida’s reflation narrative and opening their wallets accordingly, Nagai says. “The weakness of consumption comes from a secular rise in precautionary savings by younger generations worried about future tax increases or diminishing pension benefits due to society’s rapid aging,” he says.

On the bright side, it isn’t just the government that has been driving Japan’s relatively bullish markets, Koll says. The Tokyo Stock Exchange lit a fire early this year, announcing it would demand “capital improvement plans” from listed companies trading below book value, which was close to half of them.

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Corporate mergers and buyouts have hit record levels since then, a sign that managers are trying to respond. “The corporate metabolism is revving up,” Koll says. “New leaders want to create a legacy.”

It won’t help if Kishida’s legacy turns out to be disarray and disenchantment, though—or kicking the can down the road for one of the world’s oldest countries, with a historic aversion to immigrants.

“Kishida’s approval rating has declined because the public is fed up with his reluctance to confront fundamental problems,” Oxford Economics’ Nagai says.

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