Shinzo Abe was elected Prime Minister of Japan on September 26. I provided a brief background on Abe as his term as Junichiro Koizumi’s chief cabinet secretary neared its end in my premium global investing service, Silk Road Investor (see SRI, 16 August 2006, A Political Summer). The new administration has begun to reveal its goals, and it’s time to take a closer look at developments in  Japan.

Abe has taken immediate action to articulate a market-friendly and pro-change message. Investors should bear in mind that although economic change remains a priority in Japan, international relations and, consequently, domestic politics will play a major role in determining Abe’s success.

His Liberal Democratic Party (LDP) will have to perform well in the upcoming July 2007 Upper House elections. (Although it's not a general election, the outcome will influence government action.) Such an election is always an extra burden for a new leader.

Abe was quick to visit China and South Korea, driven by the demands of electoral politics. Traveling to  China first was also a good public relations move, as it emphasized that Japan views China as an important neighbor worthy of the “first visit,” though it’s common knowledge that the US is Japan’s main international ally.

Establishing smoother relationships with its neighbors will undoubtedly give Abe more leverage domestically and will, therefore, allow him to more easily implement economic changes.

Keep in mind that Abe gained national prominence in 2002 by pressuring North Korea into allowing five kidnapped Japanese citizens to return home for a brief visit. He became a political star when he then successfully argued that  Japan shouldn’t allow the victims to be returned to North Korea as planned.

His credentials as a nationalist are strong--so the opposition can’t touch him--and the Japanese have felt comfortable with him from the start of his term. In this context, Abe will be able to advance his economic agenda, an extremely positive development for long-term Japanese equity market returns.

North Korea’s latest actions have provided Abe an opportunity to demonstrate toughness and to generate a consensus among neighbors in case Japan decides to impose sanctions of its own on the rogue regime. And closer economic ties among Japan, South Korea and China would also stimulate Asian economic growth.

Another aspect of the Abe transition concerns the new prime minister’s administrative appointments. There are two main entities at issue: the cabinet and the Council on Economic and Fiscal Policy (CEFP). The CEFP is extremely important to investors because it’s the main economic policy-making body for Japan. It’s headed by the prime minister and includes the chief cabinet secretary, the minister of state for economic and fiscal policy, the minister for internal affairs and communications, the minister of finance, the minister of economy, trade and industry, the governor of the Bank of Japan and four private-sector experts.

The appointments of the four private-sector experts are critical when it comes to the direction as well as the credibility of the CEFP because they represent the dynamic, market-friendly section of the council. And Abe’s appointees--including Fujio Mitarai, former chairman and CEO of Canon and current chairman of Nippon Keidanren, Japan’s most-important business organization, and Uichiro Niwa, a restructuring expert and chairman of Itochu Corp, one of the biggest trading (imports/exports) companies in Japan --are top of the line. Economists Taketoshi Ito of Tokyo University, who's done a lot of work on deregulation and has taught at the University of Wisconsin-Madison and Harvard University, and Naohiro Yashiro of International Christian University, the former president of the Japan Center for Economic research, a premier economic think tank, and also a deregulation and medical systems economics expert, round out the CEFP.

The CEFP has presented the following economic policy goals: increasing productivity through innovation; making the labor market more efficient; building an economy open to the world--and, in particular, Asia; deregulating the agricultural market to expand the domains in which private-sector firms can participate; creating market-based medical and nursing-care systems; shifting to more-efficient uses of assets; and granting more autonomy to local governments.

As far as the economy is concerned, I've made the case for Japan’s long-term potential on numerous occasions. The main idea is that the current economic cycle in Japan will be stronger and more enduring than most market observers anticipate. This view is based on the structural changes taking place in the Japanese economy (including changes in government financial institutions) and the end of deflation, as well as the fact that, as many years of depression come to an end, the Japanese are now much more optimistic about the future than they've been for a long time.

The increased participation by local investors (retail and institutional) in the Japanese markets should gain traction as the Japanese economy steadily improves and risk tolerance rises. More than $250 billion is expected to come into the market in the next five years--9 percent of the Nikkei 225’s total capitalization. Looking at the high percentage of their assets that Japanese households allocate to deposits accounts, the above target looks quite feasible, especially as an increasing number of vehicles for investing in the markets are made available to Japanese investors.

Japan, as I’ve previously noted, is in a secular bull market that commenced in 2003 when the TOPIX Index was trading at around 800. (I refer to the TOPIX Index, the capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange, because it offers a more-comprehensive picture of the Japanese market.)

Hence, although the Japanese market hasn’t performed well this year, I still recommend exposure to it. In addition, I also have favorable views of Asia, “Old” Europe and  Russia .

Yiannis G. Mostrous is editor of Growth Engines.

© 2006 Yiannis G. Mostrous
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