Japan: the sun continues to rise
Ever since Prime Minister Shinzo Abe came to power in 2012, bringing with him his ambitious “three arrows of reform”, investors have faced the question of when — or whether — to increase their exposure to Japan. Has the moment finally arrived or are there still clouds on the horizon in the Land of the Rising Sun?
For some investors, the election of Shinzo Abe as prime minister in December 2012 signalled the start of a new era for Japan as a place for mainstream investment. Mr Abe’s radical manifesto — quickly dubbed ‘Abenomics’ by commentators — was a three-pronged assault on the deflation that had gripped the country since its property and stock market bubbles burst, resulting in ‘the lost decade’ of the 1990s.
The Nikkei peaked in December 1989 at an intra-day high of 38,957, then collapsed as the Japanese property bubble burst, dragging the financial and commercial sectors down with it. In March 2009, it stood at just 7,055, 82% below its peak. Successive governments had tried and failed to reverse the economic torpor (for example, quantitative easing — QE — was first used in Japan between 2001 and 2005), causing many Western investors to write off Japan as a ‘value trap’. The Bank of Japan’s (BoJ) easing always seemed half-hearted and it tightened policy too early.
Perhaps inspired by the policies of the US Federal Reserve and Bank of England in responding to the global financial crisis, Abenomics comprised ‘three arrows’ of ultra-low monetary policy, huge fiscal stimulus, and much-needed social, economic and financial reforms. After years of false dawns, many investors felt the package stood a good chance of working. But was it really “different this time” or would the optimists be burned yet again? Our strategic asset allocation committee decided that Mr Abe did indeed represent a new opportunity for Japan and we increased our allocation accordingly.
It has been a rollercoaster four-and-a half years since. Initial progress was impressive, particularly the support Mr Abe won from the BoJ. But many global investors pulled out in the first six months of 2016 when optimism gave way to disappointment about the government’s ability to implement the required reforms and boost inflation. There was a feeling that the momentum of Abenomics was fading.
Keeping the faith
Faced with the extensive selling of global investors, we had to hold our nerve — but where were the positives? The stock market seemed only to respond positively to sentiment about Chinese, and therefore global, economic growth and yen weakness; and the economy was delivering only lacklustre growth.
However, we continued to see value in Japanese equities, largely driven by undemanding valuations, microeconomic factors and asset allocation:
- a radical improvement in return on equity as a result of the revolution in corporate governance that had begun in the previous decade
- increasing shareholder focus should lead to the return of a cash mountain by way of dividends and buybacks
- the huge potential for reratings as pension funds and the BoJ allocated to equities
- the huge potential for multiple reratings as positive inflation expectations and the hunt for yield lead households into equity ownership.
We preferred exposure to domestic stocks rather than the ‘weak yen, export-driven’ behemoths bought by many global investors. As active investors, we could favour better-quality, higher-growth stocks with a commitment to corporate governance rather than simply buying large-cap index exposure.
This renewed commitment paid off. In 2016, Japan was again one of the best performing developed markets, returning over 30% in sterling terms (boosted by the post-Brexit fall in the pound) and 20% in local currency terms.
We remain positive on Japanese equities as valuations are at a significant discount to other regions. Higher multiples have been the main driver of returns elsewhere since 2013; but earnings have been the sole driver in Japan, where profits have nearly doubled, yet the market’s price/earnings ratio has fallen from 18x in 2012 to c.15x now.
While hope has been the main driver of returns elsewhere, there has been virtually no hope priced into the Japanese market as seen by the overseas selling last year. Moreover, significant changes in corporate governance are leading to record levels of share buybacks and an increase in dividends. These positives are independent of the supply-side reforms of Abenomics.
Our view is also shaped by several other factors. First, Japanese equities have often been seen as a geared play on global growth, and the latter is set to recover. Secondly, despite initial scepticism, the structural reforms of Abenomics are bearing fruit. For example, since 2012, one million more Japanese women have jobs, pushing the female labour force participation ratio to a record 66% — it is only 64% in the US. Deregulation has also led to a record level of inbound tourists, from eight million in 2012 to 20 million in 2015.
Lastly, the equity market will continue to be supported by institutional investors. There could be as much as 19 trillion yen of buying potential from buybacks (c.4% of the market capitalisation of the Tokyo Stock Exchange), the BoJ and pension funds (the Government Pension Investment Fund — the world’s largest — had 21.5% in equities at the end of September, versus its target of 25%).
As we approach the fifth anniversary of Mr Abe’s election as prime minister, it seems it has been different this time, although it certainly hasn’t been plain sailing.