The Abe government has released the 2015 update to its closely watched "third-arrow" growth strategy (Japan Revitalization Strategy - Revised in 2015). Record-high corporate profits in 2015 are driving expectations for a recovery in consumption as wages increase. However, corporate investment has so far failed to pick up, which is an indication that corporate management lacks sufficient confidence.

Such investment is needed longer term as part of productivity improvements aimed at getting around constraints on Japan's shrinking working-age population. This is the key focus of the growth strategy's 2015 revision. The strategy shows that the success of government policy hinges increasingly on private-sector actions. We will be watching to see how companies respond this year to the Corporate Governance Code in terms of selling cross-shareholdings and improving capital efficiency for signs of coming change in the Japanese economy.

Third arrow (2015)

We continue to field numerous queries from foreign investors regarding the Abe government's "third arrow" growth strategy-specifically, where it now stands and what kind of changes it can be expected to produce. With electric power industry reforms now out of the way, the remaining potential areas for deregulation, such as lifting the ban on casinos, look likely to have little impact on the macro economy. In reflection of this situation, a key theme of the 2015-version growth strategy is Japan's need for a "productivity revolution."

First of all, this entails stronger corporate governance-the key area of interest for investors. The growth strategy calls for increased dialogue between companies and investors in support of stronger corporate earnings power. It is not evident why stronger corporate governance will enhance earnings power, and while investors are interested in how Japanese companies will adapt to the new Stewardship Code and Corporate Governance Code, there has been little discussion of what exactly is being talked about here and what issues need to be addressed.

Clarification of what needs to be done can be found in the UK's Kay Review and Japan's Ito Report. In short, goals to be achieved under these new codes should reflect the economic community's current understanding of where the problems lie. For Japan, the consensus not only among investors but also among academic and industry leaders is that Japanese companies lack sufficient earnings power. The Japanese government's basing of policy on a combination of codes and reports as in the UK is consistent with Japanese society's emphasis on consensus.

Governments can enact hard laws and by-laws, but these are unlikely to be sufficiently effective absent a common spirit among all parties concerned. An example of this was the Japanese government's effort to deregulate capital flows in the 1980s, which ended up being effectively derailed by corporate cross-shareholdings. For such policies to truly bear fruit, they must be premised on a consensus understanding of what needs to be done. While adherence to the new Corporate Governance Code is mandatory under the Tokyo Stock Exchange's requirements for listed companies, corporate autonomy continues to be emphasized via a comply-or-explain mechanism.

We believe that this time is different for Japan's corporate governance reforms, as policy and consensus are at last moving in sync. A Nikkei article on July 16 reported that some 60% of major Japanese companies reduced cross-shareholdings in fiscal year 2014. While disposing of cross-shareholdings and bringing in independent outside directors is not going to increase corporate earnings power in itself, we think Japanese companies will also be forced by the country's graying demographics and increasing globalization to replace their current emphasis on scale and stability, that is on maintaining the status quo, with an emphasis on the efficiency and growth sought by investors. We think stronger corporate governance heralds a coming corporate revolution that we intend to keep close watch on.

A second aspect of the productivity revolution called for in the growth strategy's 2015 revision is an accelerated push in such areas as the Internet of Things (IoT), Big Data, and artificial intelligence. The government intends to support corporate efforts in these areas, which has us anticipating a more-sophisticated industrial structure accompanied by changes in the employment structure.

A third aspect is labor reform, including efforts to address Japan's overly long working hours, to provide more employment opportunities for women and the elderly, and to integrate employment with education. Speaking at an investor seminar on 29 June, Haruko Arimura, the Minister in Charge of Women's Empowerment, said that the government aims to have women account for around 30% of leadership positions by 2020 and that new legislation will require companies with over 300 employees to establish and report on behavior-related objectives in this area. With Japan showing no interest in offsetting its population decline with increased immigration, we see increased labor participation by women as an effective way of easing supply constraints.

The 2015 growth strategy also continues to call for government support of the service industry in its efforts to enhance productivity and for further execution of projects already under way (including autonomous driving, hydrogen energy, and robots).

Japanese economy entering a virtuous circle

Japanese companies earned record-high profits in the fiscal year ending March 2015 (¥21.2 trillion in aggregate net profit for companies on the Tokyo Stock Exchange). Return on equity (ROE) for publically held companies had already reached 8.5% as of May 2015, but this was mostly the result of a weak yen and other cyclical improvements in the operating environment. In fact, ROE has yet to sufficiently reflect either an improvement in capital efficiency accompanying the unwinding of cross-shareholdings or a shift in management emphasis toward profit margins. Japanese ROE levels are coming more closely in line with the US and Europe, but they remain too low. To put it another way, Japanese companies have substantial room for structural improvements. We meanwhile look for a virtuous cycle in which recovery in consumption is triggered by wage hikes that do not threaten profit margins (such as wages at major corporations which were up 2.52% year-on-year as of June).

The My Number (Social Security and Tax Number System) to be introduced in October 2015 will require stronger cybersecurity that should support ongoing growth in corporate IT investment. In addition, the corporate tax rate is scheduled to be cut from 34.62% in 2014 to 32.11% in 2015 and 31.33% in 2016-the growth strategy calls for a reduction to below 30% as soon as possible as a matter of industrial policy. Assuming the Trans-Pacific Partnership (TPP) is concluded this year, we can expect companies to invest in increased manufacturing capacity ahead of a likely expansion of trade. Unification of trading rules will meanwhile make it easier to predict other countries' policies and therefore facilitate expansion of overseas operations.

The weak yen has driven a sharp increase in foreign tourism to Japan, as the number of foreign tourists totaled 13.41 million in 2014 and rose 44.9% year-on-year in the first five months of 2015. Foreign tourists spent around ¥2.03 trillion in Japan in 2014, a scale of consumption with considerable macroeconomic impact. With the Tokyo Olympics coming in 2020, domestic service industries will likely be investing in capacity expansion aimed at accommodating even greater tourist inflows.

Future points of focus

Because Japan's population is expected to decline over the long term, companies need to invest less in expanded scale than in improved efficiency. This includes shareholder return measures conducive to improved capital efficiency. The growth strategy's 2015 revision calls for the government to play a gradually decreasing role, as the success of government policy hinges increasingly on private-sector actions.

We expect near-term corporate profits to be supported by a full-scale rebound in the US economy and by currency stability. Our main scenario has the Nikkei 225 Index reaching 22,500 by end-March 2016. However, we also think that further progress in government-led corporate reforms underpinned by consensus support from Japan's business community could bring visible improvement in corporate earnings power and capital efficiency within the next two to three years. The results of these reforms are not entirely covered by our main scenario in terms of timing and details; instead, we have chosen to place them under our positive scenario.

For signs of coming change in the Japanese economy, we will be watching to see how companies respond this year to the Corporate Governance Code, specifically the twin issues of selling cross-shareholdings and improving capital efficiency.