"Japan Country Risk Report Q2 2016" Published

Our real GDP growth forecast of 0.6%, compared with consensus expectations of 1.1%, reflects our bearish view on external demand amid a continued unravelling of the Chinese economy and renewed recession risks in the US, which look set to compound domestic structural economic woes. That said, lower energy prices pose upside risks to growth, should businesses use windfall profits to boost investment.

The BoJ's latest monetary policy tweaks mark an incremental easing amid already extremely loose monetary policy in Japan. As debt continues to be monetised, the money supply will rise, feeding through into higher consumer price inflation following years of stagnating prices.

The FY2016 budget intends to narrow Japan's fiscal deficit to 6.6% of GDP, but continued supplementary budgets and weak real GDP growth suggest this will not be achieved. While total government debt as a share of GDP is stabilising thanks to the Bank of Japan's policies, the risk of a fiscal crisis in Japan over the coming years remains acute.

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Japan's external accounts have been a major beneficiary of the decline in global energy prices, with the trade account heading back to balance from a significant deficit and the current account surplus surging. However, this increased surplus partly reflects weakness in domestic investment as businesses have used the windfall of cheap energy to increase overseas assets rather than domestic investment, which will prevent a broad-based recovery in the domestic economy.

The dollar appears to be forming a significant topping pattern against the yen, with potential for significant yen strength over the first few months of 2016. While there are clearly structural headwinds facing the currency as a result of the huge fiscal deficit and likelihood of increased debt monetisation, the bullish medium-term case is becoming increasingly visible.

As Japan's megabanks embark on aggressive sales of their cross-shareholdings in line with the government's aims of improving corporate governance, this will provide the dual benefit of improved capital allocation and increased capital adequacy. Both of these factors suggest that banking equities will outperform the broader market over the medium term.

Major Forecast Changes

We have revised our forecast for the Japanese yen stronger due to a number of positive technical and fundamental factors, from falling oil prices to our expectation of rising global risk aversion and the potential for the US Federal Reserve to err on the side of caution with regards to interest rate hikes amid slowing US growth momentum. We now see the yen averaging JPY115.50/USD in 2016, expecting further appreciation from the 2015 average of JPY121.04/USD.

Key Risks

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