January 7, 2014 3:04 am JST

Will global economy be 'just right' for Japan equities in 2014?

HIROAKI TAKAI, Nikkei staff writer

TOKYO -- As the surprisingly rough start of trading this year suggests, continued gains in Japanese stocks are premised on a delicate balance of factors.

    For the first time in six years, the market did not ring in the New Year on Monday, the first day of trading in 2014, with an up day. Even so, SMBC Nikko Securities' Ryota Sakagami is confident about the outlook.

    The chief equity strategist notes that one of the country's biggest labor unions, representing workers for telecom group NTT, will seek an increase in basic pay this spring for the first time in seven years. As Japan tries to wrestle free of deflation, this year's wage negotiations -- a tradition dubbed "shunto," or "spring struggle" -- will attract particular attention overseas. To sustain the rally, he argues, "big corporations like automakers need to start handing out raises, showing foreign investors that Japan really has changed."

     Even as such glimmers of hope appear in Japan, the U.S. Federal Reserve's reduction in bond buying is casting a shadow from afar.

     Investors are starting to worry that higher long-term interest rates may put the brakes on the U.S. stock market's bull run. Emerging-market equities and currencies would also suffer.

     Late last year, the 10-year Treasury yield climbed back above 3%. The Fed's move toward an exit from unconventional monetary policy, combined with a robust U.S. economy, "have made it hard to keep the 10-year yield in the artificially low range of below 3%," says Yasunari Ueno, chief market economist at Mizuho Securities.

     A shift in investment from stocks to bonds is a natural part of an economic recovery, which in turn pushes up interest rates. But problems arise when rising interest rates start to drag on corporate and consumer borrowing as well as stock prices. Ueno sees the tipping point at 3.5%. If the 10-year yield neared 4%, stocks would start to look overvalued relative to corporate earnings, he says.

     The Japanese equity rally hinges on the yen staying weak against the dollar, and this depends to a large extent on U.S. interest rates returning to normal. The Fed has a narrow path to tread, but with expected U.S. inflation tame, at around 2%, it can take its time. The market consensus holds that as disinflation persists globally, U.S., Japanese and European central banks can keep monetary policy loose without fear of sending consumer prices too high.

     But a creeping change threatens to undermine this scenario. The world's working-age population is heading into decline for the first time in nearly a half century, notes Kenichi Hirayama, chief fund manager at Tokio Marine Asset Management. Fifteen- to 64-year-olds peaked at 65.81% of the total last year, United Nations estimates show. Meanwhile, the active-spending 35-54 cohort is expected to continue growing until 2030.

     This means that 2014 marks a change in global supply and demand that will make final goods and services prone to consumer-driven inflation, Hirayama says. Add in rising resource prices stemming from such factors as geopolitical risk, and inflation expectations could easily get out of hand.

     Some have hailed the ongoing rally in developed-nation equities as the return of the not-too-hot, not-too-cold "Goldilocks market" of the mid-2000s. But the start of a multiyear shift in U.S. monetary policy, Japan's bid to end nearly two decades of deflation, and the biggest change in global demographics in half a century will make it hard to maintain the right temperature in 2014.