Investors are familiar with Japan’s Icarus-like equity market performance in the last century, and its precipitous fall after the asset bubble burst. But not as many know that the country now offers companies seeking to transform themselves from stable domestic cash generators to Asian -- and even global -- growth stories, as they increase sales in markets abroad. For investors, allocating to Japan in this context requires weighing up these opportunities alongside a number of important risks. Our team is positive on the outlook for Japan overall, but over the coming months, we will be keeping a close eye on issues such as currency fluctuations and domestic monetary policy, as well as the impact of geopolitical and trade tensions.
Beyond the Lost Decade
In 1989, the year Japan’s Nikkei index hit its record high of 38,915, Japan’s weighting in the MSCI World Index peaked at just over 40 per cent. By 1997, after asset deflation and sluggish growth plagued Japan during what would be called its ‘Lost Decade’, that weighting had shrunk to 12 per cent, and now stands at around 9 per cent.
In recent years, though, the country’s outperformance rekindled investors’ interest, and reminded global allocators that Japan still merited a standalone investment. We certainly see opportunities here, but whether this is sustainable depends on the extent to which the effects of Abenomics, including its signature corporate governance reforms, outlast their namesake, and how long the currency remains relatively weak so that Japanese companies with overseas businesses are able to take advantage of the global growth cycle as long as it continues.
The election of Shinzo Abe as prime minister in 2012 ushered in the latest phase of ultra-easy quantitative monetary policy combined with fiscal stimulus and a push for corporate reform. Abenomics got a tailwind from global growth and loose monetary policy around the world. The yen weakened, which helped lift corporate profits to record highs last year, and pushed the Nikkei 225 to a 26-year high earlier in 2018.
Source: Thomson Reuters, 25 June 2018
Source: Thomson Reuters, 30 June 2018
Source: Japan’s Ministry of Finance, 31 March 2018
The so-called ‘third arrow’ of Abenomics is a set of reforms with corporate governance and stewardship codes aimed at leading companies toward best practices, and many have embraced this. The number of listed companies issuing integrated reports to explain their plans to increase long-term corporate value surged from only a dozen in 2008 to 411 last year, according to Disclosure & IR Research Institute Ltd. In the long term, we believe that this heightened emphasis on governance and transparency should lead to sustainable long-term growth and increasing corporate value, and also boost Japan’s appeal with overseas investors.
Valuations in Japan remain relatively low, compared to their global peers, partly thanks to Abenomics, which weakened the yen and lifted return on equity and earnings per share (EPS). In our view, this creates some attractive entry points.
Source: Thomson Reuters, 25 June 2018
Silver lining of demographic cloud
While the overall picture looks bright, Japanese equity markets are particularly vulnerable to external factors, and can be highly cyclical and volatile. For example, foreign investors typically own nearly a third of shares of listed Japanese companies, which is comparable to the US market where the capitalisation is more than four times greater. Non-Japanese market participants typically account for nearly two-thirds of Japanese daily trading volume, and whether they are net buyers or sellers in any given week can determine short-term market direction. For international investors, we believe the key here will be to monitor factors that affect market behaviour, and the flexibility to hedge some of these risks with instruments such as index futures and options will be an important part of the investment toolkit. Japanese equity managers will also need to look carefully at stock ownership of a company to gauge whether owners are long-term holders or shorter-term traders and understand the associated risks.
The low interest rate environment continues to take a toll on Japan’s financial sector, making it unlikely to outperform global peers. Wage growth, which had lagged the economic recovery, has shown signs of picking up and could pinch profits. We believe that this makes a strong case for the value of active management, underscoring the necessity of separating winners from losers, and the unreliability of betting on Japan as a whole. In this context, talented active managers will be able to identify trends and spot opportunities for alpha in a market where the difference between the best and the rest is significant.
Japan’s demographic situation may not bode well for the long term, but it does have a silver lining in that it has given companies an incentive to internationalise and pursue growth abroad. The country now has the highest percentage of elderly citizens in the world, and over 40 per cent of the population is expected to be over 60 years old by 2050. In response to this shrinking domestic market, the number of firms with overseas sales accounting for around a third or more of their business has been on an upswing.
Source: eol Inc, 31 December 2017
Japan’s automobile and major manufacturing industries make its large caps a good play on global growth. Japan’s small- and mid-sized companies also offer opportunities for investors seeking undervalued companies, and more than a third are not covered by any sell-side research. Investors in this part of the market will need to understand what is driving each company’s revenue growth, to determine whether the greater risks it faces are domestic or external.
The tragic earthquake and tsunami that struck the country in March 2011 revealed to the world the extent to which the country remains a vital part of the global supply chain for specialised components and equipment for autos, computers and other electronics -- and while Japan remains geologically vulnerable to seismic events, we think it’s worth remembering the speed with which industrial and manufacturing facilities recovered after the 2011 disaster.
Protecting against risk using FX forward contracts
Japan’s central bank is likely to lag its global peers in normalising policy - we don’t see any signs of a tightening just yet. One effect of its massive easing scheme was the weaker yen, which has long been a perceived safe-haven currency backed by the country’s current account surplus, and tends to appreciate in times of risk aversion.
The ever-present possibility of foreign exchange volatility makes the case for hedging, since the yen tends to move inversely to equities. Of course, this correlation does not always hold, and Japanese stocks rose in the second half of last year despite an upwardly creeping currency. But generally, a stronger yen makes exported Japanese goods more expensive and therefore less desirable in overseas markets, and deflates the value of Japanese companies’ overseas profits when repatriated.
Indeed, we often observe that the yen can be a critical element for Japanese markets, particularly in the short term. Making an active decision about how much of an allocation to hedge is key for some investors, as they strike a balance in portfolios between efficiency and risk. While hedging can be expensive, global returns can be wiped out by foreign exchange market moves, so each investment must be considered from a risk/return perspective to determine whether or not it is worth the hedging costs.
Hedging with forward FX contracts can have a significant impact on returns. For example, the MSCI Japan index, expressed in US dollars, earned annualised returns of 0.62 per cent in the 12 months from September 2013. If currency exposures were hedged as the yen weakened in that period, the index returned 11.90 per cent. (1)
Bond market liquidity dries up as Bank of Japan takes it easy
Japan’s fixed income market is dominated by a single player: the Bank of Japan (BOJ), with Governor Haruhiko Kuroda reappointed earlier this year to another five-year term.
Under its yield curve control policy, the BOJ aims to guide short-term interest rates at minus 0.1 percent, and the 10-year Japanese government bond (JGB) yield around zero percent. The BOJ has a loose pledge to increase its government bond holdings at an annual pace of 80 trillion yen, though its actual purchases have slowed to an annual pace of roughly 50 trillion yen as JGB market liquidity shrinks due to the central bank’s massive JGB buying.
Japan’s national balance sheet makes it challenging for the BOJ to exit its massive stimulus, for fear of driving up the interest rate on the national debt. The country has posted government deficits since the early 1990s, as its tax revenue plummeted and policymakers turned to fiscal spending to attempt to spark growth. Its public gross debt-to-GDP ratio stands at nearly 240 per cent, the highest among developed countries.
Economic and political risks
US trade protectionism has risen and is threatening Japan’s exports, particularly to China, which is bearing the brunt of rising tension. Japan’s annualised gross domestic product contracted in the first quarter of 2018, snapping a streak of eight consecutive quarters of growth. A sales tax hike slated to take place in October 2019 could help Japan get its balance sheet in order, but might sap consumption, which accounts for nearly two-thirds of GDP. The weaker yen was engineered to spark inflationary pressure, but the rise in consumer prices remains far short of Kuroda’s ambitious initial target set in 2013 of two per cent within two years. The target was extended six times before being abandoned in April.
Regarding domestic risks, we see monetary policy as another important long-term factor. The BOJ will eventually take cautious steps toward an exit, such as further tapering its asset purchases, or raising its 10-year JGB target of zero to a range of zero to 0.25 per cent. As rates edge higher, the yen is likely to follow, which would bring headwinds for exporters and the broader economy, depressing both revenue from abroad as well as profits earned from the domestic market.
Japan’s political situation is relatively stable compared to some European countries, though Abe’s support ratings wobbled after a recent spate of domestic scandals. However, we don’t see much reason to believe that Abe’s Liberal Democratic Party will lose its hold on power, and it would likely maintain his economic policies even if he were to stand down.
While Japan has yet to confirm that it has achieved a sustainable domestic growth path, opportunities remain for investors who take a selective approach. We believe that valuations are attractive, but each investor must consider risks including currency, trade tension and global growth trends to determine whether an allocation to Japan makes sense.
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