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Japanese prime minister Shinzo Abe has a plan for economic revival, and, with typical Japanese symbolism, it relies on three arrows. Two of his three arrows have already been launched: unprecedented monetary easing to achieve a 2% inflation target and a large deficit-financed spending program. The first two arrows are fairly conventional policy prescriptions, acknowledging that the potential magnitude of the monetary easing is anything but conventional. The third arrow, which the market is eagerly anticipating, is structural reforms to unleash growth. Japan is notorious for its inflexible, overregulated, tradition-bound economy. For Japan, the third arrow is an imperative.
But Japan is not the only country looking to launch a so-called third arrow. Given that the world's major central banks outside of Japan have extended conventional and unconventional monetary policies about as far as they comfortably can and may be approaching the peak, a successfully implemented third arrow approach could launch the next push of momentum into the world economy. In most cases, it will take courageous and cooperative political leaders. While on balance many programs will ultimately be pro-growth, they may not be in the short term, nor will they be positive for all sectors of the economy. Identifying the implications will be important for positioning one's portfolio to take advantage of the inevitable upcoming changes.
How Third Arrows Can Spur a Bull Market
We have seen a few arrows launched in Europe already, and they have helped inform our investment strategies. While the United Kingdom incorporated significant structural and fiscal reforms into its initial response to the 2009 downturn, British officials have continued to tinker with tax rates, both personal and VAT (value-added tax); the availability of credit; employment education; and research innovation. Most programs have been fairly incremental in nature, but they have provided support for U.K. economic growth and a positive tone for the U.K. equity market. (See Table 1.) Some sectors positively affected, such as real estate, have done exceptionally well, and were targeted in our investments. As for U.K. employment, it's the first time since 1999 that private-sector employment has grown faster than public-sector employment, according to GaveKal Research. It's those types of third arrow results that are structurally conducive to a bull market.
Source: Source: Bloomberg. Data as of October 15, 2013.
Sharp market fluctuations can materially change the performance of equity markets. During other time periods, the equity markets may have experienced negative performance.
Past performance is no guarantee of future results.
For illustrative purposes only and does not represent any Lord Abbett mutual fund or any particular investment.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. These risks can be greater in the case of emerging country securities.
"Structural reform" was a key phrase that European Commission president José Manuel Barosso used last year, when he pointed out the European Union was moving away from more austerity and into the development of "pro-growth" policies to deal with Europe's lingering recession. While the actual reforms have been spotty up until now, this proclamation was the turning point in how investors viewed the European equity markets, and it significantly lowered the perceived European risk premium.1 Unfortunately, political instability and rudderless leadership in a number of countries have delayed what we believe will be inevitable economic reform.
Keep Your Eyes on Mexico
It's not just the developed world struggling with reform. One of the more bold third arrow approaches being launched is in Mexico, where the three main political parties, together with the new president, all agree that the economy is hampered by structural shortcomings in productivity and infrastructure. In a sign of solidarity, they have signed the "Pact for Mexico," which details an ambitious agenda of reform, focused on labor laws, wage policies, education, antitrust issues, infrastructure, and, most important, energy reform. It's so massive that the cost/benefit mix by industry will be complicated. But there seems to be ample room to identify winners and losers as this far-reaching third arrow gets launched over the next few years.
Further Reforms Needed in Japan
Which brings us back to Japan and the imperative of Abe's third arrow. The initial launch is upon us with the hike in consumption tax in 2014. Many investors fear the economic momentum provided by the first two arrows will be derailed with this tax hike. We would likely agree if further reforms were not implemented. However, if sustainable economic growth, not continuously higher taxes, is the only way out of Japan's self-induced fiscal trap, then there must be more. As we have seen over the last 12 months, structural economic reforms are a great tonic for equity markets, and there will be winners and losers for us to identify. With that in mind, an alternative way to view Abe's tax hike is that he understands that Japanese economic revival is not just about printing and spending money, and, most important, that he has the necessary political will to fully launch the third arrow in time.
A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent in international investing, including those related to currency fluctuations and foreign, political, and economic events. The securities markets of emerging countries tend to be less liquid, especially subject to greater price volatility, have a smaller market capitalization, have less government regulation, and may not be subject to as extensive and frequent accounting, financial, and other reporting requirements as securities issued in more developed countries. Further, investing in the securities of issuers located in certain emerging countries may present a greater risk of loss resulting from problems in security registration and custody or substantial economic or political disruptions. No investing strategy can overcome all market volatility or guarantee future results.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.