Another black swan in Japan on Sunday?

As the October 27th House of Representatives election approaches, global investors are once again focusing on Japan.

On the 22nd, Barclays stated in its latest research report that the ruling party in Japan, the Liberal Democratic Party (LDP), and its ruling ally, Komeito, are facing their biggest governance crisis since 2009.

Previous opinion polls indicate that the ruling LDP may lose its current majority for the first time since 2009, but the LDP and Komeito alliance are likely to achieve the goal of Prime Minister Shizo Abe retaining the majority.

Barclays believes that if the LDP and Komeito alliance lose the majority but can still form a government, the Bank of Japan is expected to remain dovish, potentially suppressing interest rate hikes, leading to a depreciation of the yen; whereas if the alliance loses too many seats to form a government, the yen is expected to appreciate, long-term bond yields to decline, and Japanese stocks to fall.

In the latter scenario, the USD/JPY may fall by 2%, the 10-year Japanese government bond yield may decrease by 7 basis points, and the Nikkei 225 index may plummet by 5%.

Regardless of the election outcome, Japan's political landscape may have profound short-term effects on the market. Similar to the historic power shift in 2009, this election may also become an unpredictable "black swan" in the financial markets.

The "Victory Line" of the LDP may be difficult to maintain

Currently, the LDP and Komeito hold 256 and 32 seats in the House of Representatives, respectively, totaling 288 seats.

The goal of the LDP and Komeito alliance is to maintain "absolute stable majority," occupying at least 261 seats out of the 465 seats in the House of Representatives. This number of seats not only ensures smooth legislative progress but also ensures that the ruling coalition has a say in various committees.

However, Barclays' report points out that the LDP and Komeito may face challenges in even securing the goal of "stable majority" with 244 seats. More worrisome is that, according to recent polls, there are concerns that a coalition government may not even secure the "simple majority" threshold of 233 seats.

Barclays' research report indicates that if voter turnout is low, or if some independent candidates return to the LDP camp, the LDP and Komeito may be able to reverse the current decline. However, according to the latest polls from Asahi Shimbun and Mainichi Shimbun, even in the best-case scenario, the likelihood of the LDP independently gaining a majority of seats remains low

Potential Market Impact of Political Changes

Barclays analysis points out that in the first scenario, if the coalition of the Liberal Democratic Party and Komeito loses the majority but can still form a government, it is expected that the current Prime Minister Shizo Abe's government policy will become more moderate, especially before the Upper House election in July next year. The market expects that in this scenario, the Bank of Japan may continue its current dovish stance, delaying the tightening of monetary policy.

In the foreign exchange market, if the Overnight Index Swap (OIS) price drops by 25 basis points, the US dollar against the Japanese yen may further rise by 2.3%. Although political uncertainty is usually detrimental to the stock market, the weakening of the yen may to some extent alleviate the pressure on the stock market, keeping the Nikkei 225 Index in a volatile consolidation phase in the fourth quarter.

In this situation, corporate earnings performance will be more important than political factors, and the depreciation of the yen is also expected to provide slight support for the Japanese stock market.

The second scenario is if the worst "tail risk" scenario occurs, that is, if the coalition of the Liberal Democratic Party and Komeito loses enough seats to form a government, the market may exhibit classic risk aversion sentiment.

Barclays expects that in this scenario, the US dollar against the Japanese yen may fall by 2%, the yield on 10-year Japanese government bonds will decrease by 7 basis points, and the Nikkei Index may plummet by 5%.

Increasing Political Uncertainty, Japanese Stock Market Facing Triple Pressure

Barclays points out that in this highly uncertain political situation, the Japanese stock market is facing triple pressure - domestic elections, the US presidential election, and corporate financial reports.

Although the goals of the Shizo Abe government are clear, the low approval ratings, independent candidates running, and a large number of undecided voters make this election result full of variables.

Historical data since the 1970s shows that when the ruling party barely maintains a majority, the stock market often experiences sustained negative impacts, and when the situation becomes clear, the stock market quickly recovers. Barclays states:

" If the Liberal Democratic Party and Komeito can hold on to the majority, the market may reassess the Bank of Japan's future rate hike expectations. For the interest rate market, LDP rule may push the short end of the yield curve higher, forming a steep bearish curve."

Of particular note is that Japan's largest opposition party - the Constitutional Democratic Party (CDP) - has proposed lowering the Bank of Japan's inflation target to "above 0%," which has been interpreted by the market as a hawkish signal that could lead to a significant increase in interest rates and a stronger yen. This contrasts sharply with the "Abenomics" implemented by the Liberal Democratic Party after its victory in the 2012 election, when the Japanese government successfully curbed the yen's appreciation through large-scale easing policies, driving the Nikkei Index to continue rising.

For the upcoming elections, Barclays advises investors to closely monitor whether the Liberal Democratic Party can maintain a simple majority and whether the Constitutional Democratic Party can gain enough seats to challenge the ruling position