Trading Japan’s snap election

Why has Abe called a snap election?

Japan’s Prime Minister Shinzo Abe has called a snap general election amid recent worries over North Korea, and also after a bounce in his own approval ratings and cabinet support for the ruling Liberal Democrat Party (LDP). Abe’s ratings dropped earlier in 2017 amid allegations of cronyism, but his tough stance in the wake of North Korea firing missiles over the country has lifted his support.

The main opposition party is currently the Democratic Party of Japan (DPJ). It appears to be imploding, supporting Abe’s decision to go for an election now.  

At this point it is worth remembering UK Prime Minister Theresa May’s decision to call a snap election when she appeared to be an unassailable 20 points ahead in the opinion polls, and the opposition Labour party was apparently torn apart by infighting and ideological differences. It’s also salient to highlight the success new French President Emmanuel Macron had in forming a new political movement that took the presidential and parliamentary elections by storm.

What is the Party of Hope?

In Japan, an alternative party by the name of Party of Hope (PoH) has now entered the arena, formed by the current governor of Tokyo, Yuriko Koike, who is extremely popular. Several DPJ lawmakers have already defected to PoH, and the party’s leader has now suggested a de facto merger whereby all DPJ candidates would run under the PoH banner in an attempt to provide a united challenge to Abe’s LDP.

The LDP endured a huge defeat at the hand of Koike’s Tokyo Citizens Frist Party (TCFP) in July in the Tokyo Metropolitan election, with Koike achieving 79 seats to the LDP’s 23. This defeat is clearly fresh in Abe’s mind, so by not waiting for the newly formed PoH to galvanise and forge a stronger comradery he is hoping to strike before public support for the new party has had a chance to build.

The PoH is basing its agenda’s on some clear populist drawcards, such as the freezing of the unpopular sales tax, cutting back Japan’s nuclear power, and pushing for greater diversity. Koike is not seen as a leader who imposes sweeping changes, but she has made a name for herself campaigning predominantly against highly unpopular policies. This is a strategy that has worked well in other countries recently.

Sales tax increase at the centre of the election

By calling the election now, Abe will cement his place at the helm of the LDP ahead of its presidential elections in September 2018. If he goes on to win the election and a further four years as prime minister, Abe will become Japan’s longest-serving post-war prime minister.

In terms of Abe’s policies, the one that resonates above all others is the prospect of raising the sales tax again by October 2019. The proceeds of the increase would be put to work directly into the real economy, with an economic package of ¥2 trillion expected to be announced and used to offer free early childcare education, as well as better care for the elderly.

Raising the sales tax comes with huge economic risks, and it also puts Abe’s policies in direct contrast to that of the PoH. While there is little time for the PoH to gain traction, there is the strong possibility that the LDP loses ground. It currently holds 321 of a possible 475 seats.

The markets and Japan’s election

Foreign inflows into Japanese equity funds have started to fall of late, even though analysts expect Japanese companies to achieve the strongest earnings per share (EPS) growth in 2018 of any developed market. Perhaps these investment flows are a reflection of Japan’s geographical proximity to North Korea and the fact that ballistic missiles have been flying overhead. For the time being this represents an escalation of tensions in the region, and while it has been felt in the markets it hasn’t become a major market event.

If North Korea does become a genuine market event, which the markets don’t expect, judging by implied volatility in various markets, then being underweight or short Japanese assets obviously seems prudent and that includes the yen (JPY).

How much will Japanese assets wear a political risk premium? Estimates for Japan’s corporate earnings outlook look favourable for further index appreciation on a favourable result.

As with any investment destination, investors want political stability and for the government to have a strong mandate. If the LDP loses over 50 seats (50 seats is seen as the benchmark) then there could be heightened anxiety in the market. If the LDP achieves less than 250 seats of the possible 475, then we could see Japanese market volatility pick up quite sharply.

Although if Abe’s party can poll well, the Japanese equity market will see this as a bullish sign. This is down to his predictable and expansive fiscal policies, and his championing of the Bank of Japan’s (BoJ) ultra-easy monetary policy experiment. In this environment, we may also see a reduction in election hedging, which could promote JPY weakness, notably against the US dollar (USD) and higher beta FX pairs.

A loss of 50 seats or more by the LDP and a belief that the PoH could be a very real challenger in the future could see the JPY find good buyers, this of course will weigh on the Nikkei 225.