Coutts Cutting Japan Stocks on Concern About Third Arrow

Coutts & Co., the wealth management unit of Royal Bank of Scotland Group Plc, is cutting holdings of Japanese shares on concern Prime Minister Shinzo Abe won't pass the structural reforms needed to boost the economy.

Coutts shifted from overweight to neutral on the best-performing developed-market equities on signs Abe will squander the early decisiveness of Bank of Japan Governor Haruhiko Kuroda, said Gary Dugan, chief investment officer for Asia and the Middle East. With a sales-tax increase approaching in April, Abe is failing to deliver on reform measures that would ease the burden of the levy, Dugan said.

"The 'third arrow' of Prime Minister Abe's recovery plan appears to be veering off target," Dugan said by phone from Singapore on Oct. 18. Coutts, the U.K. company founded in 1692, managed 33.1 billion pounds ($53.4 billion) of assets as of June 30. "On the government side, things are just slipping. The worry is that Japan is controlled by pressure groups."

Inflation accelerated and growth quickened after Kuroda's unprecedented decision in April (TPX) to double the monetary base of the world's third-largest economy. While the signs of progress drove the Topix index to an almost five-year high in May, equities have since slumped about 5 percent as investors wait for Abe's so-called "third arrow" of structural reform to make the economic recovery self-sustaining.

Sales Tax

Abe, grappling with a public debt more than twice gross domestic product, is implementing the previous government's plan to raise the sales tax to 8 percent from 5 percent, the first increase since 1997. He announced a 5 trillion yen ($51 billion) stimulus package on Oct. 1 to cushion the blow, which a Cabinet Office statement showed includes public-works spending and tax breaks for companies. Specific measures will be explained in early December, Abe said.

"A lot of people were expecting more detail," Dugan said. "And now we're hearing stories about political infighting and pressure groups are saying 'please don't touch this, please don't touch that'."

Abe may have to put off plans for significant deregulation of the labor market in special economic zones, including lifting restrictions on working hours for white-collar workers, the Nikkei newspaper reported on Oct. 18.

Japanese farmers, which benefit from tariffs to protect local agriculture, oppose trade-liberalization talks with the U.S.-led Trans Pacific Partnership group of nations. Rice has a tariff of 778 percent.

Backing Away

Abe may also be backing away from a pledge to require companies have outside directors on their boards, according to a draft document prepared by the Justice Ministry that was obtained yesterday. New rules will only require companies to justify the lack of outside directors, without forcing them to appoint any independent board members, it showed.

Coutts turned positive on Japanese shares a year ago as signs emerged that Abe may win power, Dugan said. The bank added to holdings around April as the BOJ said it will seek to drive inflation (JNCPIYOY) to 2 percent. Coutts remained "maximum overweight" until this month, when it started selling out of some Japanese equity funds on concern Abenomics was stalling, Dugan said.

The private bank is watching for Abe to restart nuclear reactors shut down after the March 2011 Fukushima nuclear meltdown, and cut corporate taxes, he said.

High Tax

Japanese businesses pay taxes of 35.6 percent, according to the finance ministry. The levies are the highest after the U.S. among Organization for Economic Cooperation and Development nations. Abe on Oct. 1 asked the ruling party to look into lowering the rate as soon as possible.

Such a step is the most crucial reform for the Japanese economy, according to Dugan. If Abe fails to do that by about December, Coutts will reduce Japanese investments even further until it holds less of the nation's equities than the benchmarks it tracks.

"The only way companies are going to give a big leap of faith and increase wages is if the government delivers on improving their cash flows by bringing down their energy bills and reducing their corporation tax," Dugan said. "Unless you get wage growth, you cannot get sustained improvement in the Japanese economy and you cannot reach the inflation targets."

Wages Slide

Regular wages for the nation's workers excluding overtime and bonuses fell 0.4 percent in August from a year earlier. The decline underscores that companies have yet to grow confident enough to start boosting salaries, even as they sit on what the BOJ calculated was 220 trillion yen in cash at the end of June.

Abe took office in December vowing to revive growth. Japan's economy expanded for three straight quarters through June, with output for the three months through September due to be reported next month.

"Buy my Abenomics," the Prime Minister said in a speech at the New York Stock Exchange on September 25. "The Japanese economy that now surrounds us is exceptionally good," he said.

Confidence among Japan's large manufacturers rose to the highest since the early stages of the global credit crisis in 2007, the quarterly Tankan index showed on Oct. 1.

"The market will hold up as long as economic data remains clear and it's got a bit of momentum at the moment," Dugan said. "But if we get more headlines that Abe fails to deliver on something else again, then in my mind I would say thank you very much, I'll just take more money out."