Japan’s snap election: why it matters

At the end of next week, Japan votes in a snap general election. You would be forgiven a shrug. The country has had 35 different prime ministers since the end of the Second World War. Some have served for less than a year; others have gone and come back again. Despite the revolving door, one party - the Liberal Democrats - has governed for pretty much the whole post-war period. Japanese politics manages to be simultaneously unstable and unchanging.

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Why you should care this time is that the outcome of the election could have a bigger impact on your financial well-being than you think. Here’s how.

Sanae Takaichi is Japan’s first female prime minister, having won the LDP leadership race last October. She thinks of herself as a latter-day Margaret Thatcher. It is not an absurd analogy. She is an outspoken and tough-minded conservative. She has risen to the top of a man’s world. Others, however, make a less flattering comparison - with Liz Truss. The Japanese PM, too, is temperamentally a spender not a saver.

Takaichi called the election to earn a mandate for a radical reflationary policy platform, offering voters fiscal stimulus - higher spending and lower taxes. She thinks the best way for Japan to escape the clutches of the world’s highest debt to GDP ratio is to grow its economy and boost healthy inflation, with wages rising faster than prices. To that end, she has announced a $135bn spending package and proposed a two-year suspension of an 8% consumption tax on food.

The response of the financial markets has been predictable. Equities have risen sharply as investors have latched onto the growth story. Bond markets, as they do, have focused instead on the borrowing that will be required to pay for it. Japan’s debts are already twice as big as its economy.

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Unsurprisingly, investors are starting to question how sustainable this might be. The yield on 40-year bonds (the long-maturity issues that are most vulnerable to debt worries) have risen above 4% for the first time. Five years ago, they were as close to zero as makes no difference. Auctions of new government debt are struggling to find support - the next sale of 30-year bonds is just three days before the election.

It is a sign that the outside world’s recent love affair with Japan may be waning. Since 2012, when Takaichi’s political mentor Shinzo Abe was re-elected, the Nikkei 225 index has risen more than six-fold, narrowly outperforming even the mighty S&P 500 over that period. Just as the country has become everyone’s favourite holiday destination, thanks to an agreeably weak currency and wonderful food, it has been the go-to investment. What it really doesn’t want to become now is the trigger for the next market blow-up.

There are two ways to view Japan’s rising bond yields. The first is the positive one. It sees Japan rejoining the rest of the world after a long and painful period of deflationary stagnation. Yields are rising because Japan is getting back to normal, with a healthy level of inflation that encourages people not to stuff their money under the mattress. The country has the luxury of borrowing in its own currency; 90% of its bonds are in the sticky hands of domestic investors; its bond yields remain low by global standards. Yes, its debts are high, but they are manageable. And if Takaichi can deliver the growth she promises, they will become more manageable still.

But there’s a less optimistic view that it would be unwise to ignore. Central to it is the fact that, while US Treasuries underpin the global financial system, American government debt is in its turn supported by Japanese investors. They are among the largest holders of US bonds. Rising Japanese yields lead to Japan wanting to hold fewer Treasuries and more Japanese Government Bonds (JGBs). They sound the death knell of the carry trade that allowed investors to borrow at no cost to invest with no risk.

A Japan-fuelled rise in US Treasury yields is bad news for everyone. It hurts the US government, which has to pay more to service its gargantuan debts. It nudges the yen higher, making Japanese exports less competitive. It is bad news for emerging markets, many of which have dollar denominated borrowings. And it hurts the owners of any asset the price of which is the present-day value of its future earnings streams.

The most obvious victim of rising Japanese bond yields could, therefore, be American technology stocks. The very same companies whose high valuations are currently propping up the US stock market. The Magnificent Seven was after all a remake of Akira Kurosawa’s Seven Samurai, and we know how that ended. That is the most direct way in which the Japanese bond market is likely to impact our own investments, even if we have never gone near a JGB in our lives.

But the damage might not end there. We are learning quite how dependent private credit and equity have been on lower for longer interest rates. Infrastructure and real estate, too, will suffer in a rising yield environment. Highly valued defensive shares will be hit too. It is hard to identify any part of the global financial markets that can shrug off rising Japanese bond yields.

This does not feel like an imminent crisis. But that does not mean we can turn a blind eye to Japan. It has the largest debt market in the world. Its central bank is no longer papering over the cracks by keeping bond yields artificially low. And its government is seeking approval to push the limits of fiscal laxity even further into uncharted waters.

If you’ve never shown any interest in Japanese elections, next Sunday might be a good time to start.

This article was originally published in The Telegraph.

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Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.