Just how stubborn is Japan’s deflation?

Consider a recent note from High Frequency Economics’ Carl Weinberg, about the World Economic Forum gathering in Davos in January. “It used to be that…sessions with the Bank of Japan governor would sell out. Not this year. Mega-Japan sessions were not on the program. The only time Japan came up was in conversations such as, ‘Is the fate of country ‘x’ going to be the same as Japan’s?’”

If investors have indeed given up on Japan, as Weinberg suggests, it may be with good reason. For years, despite the obvious pitfalls, Japanese policymakers have remained doggedly optimistic about licking deflation. As time goes by and they miss their inflation target yet again, they simply revise forecasts so that inflation remains forever just over the horizon.

But if investors have finally embraced a “fool me once” view after years of false hopes, they may miss out on one of the bigger market surprises of recent years. Some analysts are becoming just as hopeful as Japanese policymakers - and bullish prospects for the economy could mean even better prospects for markets.

“Our sense is that the economy is close to full employment,” said Peter Berezin, who runs global investment strategy for BCA Research. “It will take time for wages to grow but they will. There’s a good chance that Japan will soon be exiting its long dark era of deflation, which will be a huge surprise to investors.”

The end of the lost decades?

There are some fundamental reasons for Berezin’s belief: the structural issues that caused deflation to first take hold in Japan’s economy, including the bursting of the real estate bubble in 1991, and corporate deleveraging, are finally coming to an end.

What’s more, the government is finally throwing the full weight of a unified set of policies at the problem. Prime Minister Shinzo Abe took office in late 2012 vowing to shake deflation, but that goal was muddled by another that worked at cross-purposes: shoring up Japan’s fiscal health. The government increased the national sales tax in 2014 to whittle down the country’s debt burden, which is among the highest in the world. The tax increase — from 5% to 8% — throttled consumption and sent the country into a recession.

Still, one of the biggest headwinds to a stronger Japanese economy is structural: its aging population. Many analysts believe the economy will struggle as long as more pensioners are relying on fewer prime-age workers.

But Berezin, and data from the Bank of Japan itself, have a different take.

The central bank’s measurement of the labor force input gap turned positive for the first time in the third quarter of last year. In simple English, that means the economy ran out of spare workers.

It’s worth noting that the input gap measurement has been positive during a few periods ever since the initial 1991 downturn, including one stretch that began in 2005, but was interrupted by the global financial crisis and recession.

A second period started in 2014, as some of the early enthusiasm about “Abenomics” bolstered growth, but it faltered along with the rest of the economy. But it wasn’t just a cooling economy that increased labor market slack, Berezin said. One of Abenomics’ most elusive components was its “third arrow” — big structural economic changes like liberalizing immigration and deregulating industries like agriculture and energy in order to complement monetary and fiscal stimulus.

Among those reforms, one of the most important was drawing more women into the labor force, a goal that was unexpectedly successful. The female labor force participation rate was 50.4% in December, compared to 47.8% when Abe took office in December 2012.

The success of “womenomics” is another reason why the Bank of Japan estimates that pretty much all the people who want to be working already are. That’s borne out by some statistics: that labor force input gap measurement in the third quarter of last year was five basis points higher than its peak in 2014 before turning negative. At the same time, Japan’s jobless rate remains low — 3.1% in December — and the ratio of job openings to applicants hit the highest since 1991 in December.

“That’s telling you this is a labor market that’s starting to really heat up,” Berezin said. He believes employers will have no choice but to increase wages to compete for workers.

What’s more, as the balance tips from prime-age workers saving for retirement to pensioners spending their savings, “the demographics are moving from being a deflationary force to a reflationary one,” Berezin said.

An ‘inflection point’?

In a recent research note, Cumberland Advisors’ Chief Investment Officer David Kotok summarized another surprising development: the Japan Gerontological Society and the Japan Geriatrics Society argue that the definition of “elderly” should be revised to refer to people who are at least 75, rather than 65, as it is now.

“Does this measure portend the end of deflation in Japan? Will we finally see changes in incomes and movement away from the two-decade malaise of no inflation, limited growth, and continuously rising savings rates as people worked longer and accumulated more money in order to protect themselves in their old age? We just might be at an inflection point,” Kotok concluded.

If so, that could be “bullish” for investors, he added. “At Cumberland, we favor Japan in our international ETF strategies. We use combinations of ETFs, some of which include currency hedges.”

Those include the iShares MSCI Japan EWJ, -0.43% and its small-cap cousin, SCJ, +0.10% .

Berezin also sees a bullish scenario for investors. If wages do pick up enough to spur inflation, that means downward pressure on the yen. “That generates a virtuous cycle for the economy, exports will benefit, and the economy will overheat some more, and inflation expectations will rise further,” Berezin said.

His investment ideas include shorting the yen, while taking long positions in “Japanese exporting companies that will benefit from the weaker yen. They don’t have too many workers and won’t get hurt from rising wages,” he said.

Companies that fit that description have grabbed headlines in recent weeks after coming under fire from U.S. President Donald Trump. Honda HMC, -0.84% just reported a blowout quarter, and its executives are hopeful Abe’s recent visit will help diffuse tensions.

Berezin also believes that Japanese banks could be a good investment “as the economy begins to reflate and the yield curve begins to steepen.” Shares of the Bank of Tokyo-Mitsubishi US:MTU are up over 8% so far this year.