By Craig Mellow

Earthquake or nothingburger? Japan's Oct. 27 election was seismic politically: The Liberal Democratic Party lost its parliamentary majority for the first time in 12 years, and only the third time since 1955. Markets' reaction was muted and contradictory. The iShares MSCI Japan exchange-traded fund nudged up less than 1%. The yen lost 0.5% against the dollar.

Investors' nonchalance may be appropriate. The LDP will probably stay in power. With the allied Komeito party, it won 215 seats in the lower house, 18 short of a majority. The biggest opposition rival, Constitutional Democratic Party, grabbed 148. That is a 50-seat jump from the last election, but still leaves no obvious path to a governing coalition. "The CDP has an opportunity to really press the LDP and position themselves for the next election," says Tobias Harris, founder of consultant Japan Foresight.

Voters' main grievance with the LDP seems to have been a series of scandals, revealed late last year, involving deputies misappropriating campaign funds. Substantive differences with the opposition, or within the LDP's factional structure, are more difficult to discern. "The results mainly reflected criticism over the slush fund scandal, rather than policy," says Shigeto Nagai, head of Japan economics at Oxford Economics.

The drivers of Japan's recent success -- stocks have gained more than a third over the past two years in dollar terms -- and abiding challenges -- remain largely in place, rooted in broader social shifts or political winds from abroad, specifically Washington.

"I'm not sure domestic politics influences stocks much," says Neil Newman, head of strategy at Astris Advisory in Tokyo.

On the plus side, Japan's shrinking and aging population has caused a structural labor shortage that is forcing wages up after decades of stagnation and making employees bolder about switching to jobs where they feel more fulfilled and productive. Better salaries can bolster consumer spending, enabling companies to increase profits even as their payroll costs rise -- in theory. "We are looking for a virtuous cycle of growing incomes, demand and profits," Nagai says.

Corporate Japan is sloughing off habitual caution to become a change agent in its own right. "Corporate leaders are not like the LDP," says Jesper Koll, Tokyo-based global ambassador for the Monex Group. "They are getting more aggressive in their investment decisions, and that's not going to change."

In the challenge column, newly unleashed inflation is outstripping those wage increases for the moment, spurring frustration with the new economic order. A stronger yen would help in a country that imports two-thirds of its food and nearly all its energy, Newman says. "The only option out there is to strengthen the yen," he says.

The government and Bank of Japan, which finally ended negative interest rates in March, tacitly agree. Nagai expects the BoJ to hike its key rate from 0.25% to 1% over the next 18 months. Koll thinks it could go as high as 1.5%.

Headwinds are blowing from Washington for the moment, however. The yen soared from a trough of 161 to the dollar in July to 141 in September as global markets anticipated accelerated rate cuts from the U.S. Federal Reserve. It has sunk back to 153 as stronger U.S. economic data put off loosening expectations.

An election victory for Donald Trump on Nov. 5 would give a further jolt to the dollar as markets anticipate that his tax and tariff policies would be inflationary, forcing the Fed to stay higher for longer, says Aaron Hurd, senior currency portfolio manager at State Street Global Advisors. His base case sees the yen strengthening to 130-135 as the Fed keeps loosening. But he's gone cautious at least until Election Day.

Continued yen weakness could be good for Japanese stocks, on the other hand. The market is dominated by multinational giants like Toyota Motor, Hitachi and Sony Group, which reap most of their earnings overseas then translate back into yen. Average earnings expectations assume 143 yen to the dollar, Koll says. If the currency stays in the 150s, profit growth could come in above 15%, instead of a currently projected 8%.

The coming period of tenuous coalition government will take some toll on the Japan story. A fiscal stimulus package promised toward year's end may balloon from 1% to 2% of gross domestic product as the LDP tries to buy back defecting constituencies with "bridges to nowhere," Koll fears. At the same time, structural reforms to bankruptcy, mergers and acquisitions, and other elements of corporate plumbing may be delayed or shelved as legislators focus on horse-trading.

Having the oldest population of any major economy, which is projected to contract by six million before 2030, is also not entirely a plus, of course. But one messy election won't stop the No. 4 economy's positive momentum.

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October 28, 2024 16:25 ET (20:25 GMT)

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