Investment focus: Japanese equities

Many of the companies that dominate the Japanese equities market have historically displayed attitudes that are viewed as unhelpful to the interests of minority shareholders, with cash tending to be hoarded instead of paid out in dividends. An economy built on innovation was viewed as sclerotic, with employees hired for life and a mire of bureaucracy evolving over time.

There has also been the question of the economy, as Japan acted as something of a forerunner for the problems that have seeped into the rest of the world. An ageing population means that more of the resources of the economy must go towards paying for their retirement, putting pressure on the resources of the state and so requiring either tax rises or lower public spending in other areas.

Older people tend to vote more and spend less than younger folk, creating a situation whereby more money was deployed to those with the least inclination to spend it. In economics, the desire and willingness to spend the extra cash received is called the marginal propensity to consume.

Policymakers trying to drive growth in an economy where growth is lacking would prefer to deploy the additional resources of the state to those who have the greatest capacity to spend more – that is, the younger cohort.

Japan’s economic growth was restricted in another way: for reasons of culture, it has never attracted migrants in significant numbers. Migrants tend to provide a fillip of youth to the population, and thus add a dynamism and desire to spend to the economy.

In this way, Japan seemed set to be an economy without growth and an equity market without return for investors.

Easy trade

About the only consistently profitable trade that seemed to come from Japan was in the bond market. Very low, and sometimes negative, interest rates were the norm in that country before they ever entered the policy toolbox of the Bank of England or the US Federal Reserve.

Therefore, investors seeking profit could borrow in yen to buy US government bonds, and the yield on the bonds, plus the currency uplift, was such that it outweighed the cost to the investor of borrowing the money. It became a very popular, easy trade for bond investors.

But it didn’t help the Japanese economy, as such a trade meant that the yen rose in value, making exports more expensive. The ageing population at home was not able to pick up the slack caused by the slowdown in exports, and the economy went nowhere. The so-called ‘yen carry trade’ became a symbol of Japan’s problems and a signal to the world that now was the time to move to risk-off strategies, for if the best the market could think to do was make a modest return on the currency and the US bond yield, it implied that there was little value in the markets globally.

Then came prime minister Shinzō Abe, who took the helm in Japan with the aim of solving all of these problems. His suite of economic measures, colloquially called ‘Abenomics’, was effectively an attempt to meld into a coherent plan a number of separate economic theories in order to prime the pump of Japanese economic growth.

The markets responded well initially – long-lost optimism returned in 2013 and the market performed well.

Abenomics attempted to push capital into the economy and equity market through a combination of three ‘arrows’. The first was record-low and then negative interest rates, to encourage those hoarding cash to spend it or otherwise deploy it in a way that would boost economic growth.

The second arrow involved increased levels of government spending as a method of increasing demand in the economy.

Cynical observers, such as David Jane, who runs three multi-asset funds at Miton, noted that both of these arrows are easy for a politician to implement, as they generally involve giving companies and individuals cash. He took the view that the real test would only arrive with the implementation of the third arrow, which involved enforcing corporate reforms and changes to employment law, and so would be unpopular.

The recent rally in Japanese stocks, with the market riding high, has meant that the global equity fund managers are now finding less career risk in buying the shares than shunning them.

Reform agenda

Alex Crooke, who runs the Bankers Investment Trust, which has increased its dividend in each of the past 50 years, remarked that the key to his recent enthusiasm for the country has been the corporate governance reforms.

He commented, ‘Over the past three years, the underlying Japanese market has been a strong performer globally, coming in second only in sterling terms to the US, which contains a strongly self-sustaining domestic economy. Plenty of investors focus, more bearishly, on ageing populations, poor profitability and disinflation, and have tended to underplay the region. Our investment thesis is centred on the belief that corporates are undergoing a variety of significant positive changes, and that this is enabling them to release value from decades of poor capital allocation and governance.’

He added, ‘The first change lies in the shift in corporate mentality towards generating shareholder value. In the past, Japanese firms have tended to hoard cash on their balance sheets, leading to either under-investment in capital expenditure and falling global market share or over-diversification into competing firms and maligned business areas, creating highly fragmented industries where businesses resist mergers or become buried in a quagmire of non-core assets. Cheap labour has compounded poor investment decisions – access to large pools of cheap available labour has reduced returns by encouraging management to add capacity needlessly.

‘The broader effect has been to produce low rates of return on equity, reducing profits and discouraging investors to the detriment of share price returns.

‘We believe this issue of shareholder value is now being seriously addressed. Since Prime Minister Abe unleashed his three arrows of economic reforms, Japanese firms have started to adopt much more Western corporate thinking. Cross-holdings are being unwound and non-core assets sold; boards are choosing to hand back cash where appropriate, as can be seen in rising dividends, pay-out ratios and share buy-backs; and firms are now taking a much more cautious approach to labour investment amid increasing shortages.’

In favour

John Bilton, global head of multi-asset investing at JP Morgan, is another who is keen on Japan, remarking that it is his ‘most favoured’ market at the present time.

The veteran investor remarked, ‘A revised set of historical national accounts data shows that the Japanese economy has sustained stronger productivity growth in recent years than previously understood – over 1 per cent per annum. While the increase in the labour force observed in the past two years is unlikely to persist given the country’s unfavourable demographics, Japan’s potential GDP growth now seems a bit higher than the 0.5 per cent we previously assumed.

‘On the cyclical front, the economy’s success in 2016, when it grew 1.6 per cent (Q4/Q4), occurred without much help from fiscal policy, which is set to turn expansionary this year. Given the Bank of Japan’s adoption of the yield curve control policy in September 2016, monetary policy may also deliver more effective support to the economy this year than last. Finally, Japan should benefit from the upturn in global manufacturing and capital spending and, in particular, improved growth in its immediate Asian neighbourhood.’

A fiscal policy turning expansionary means that government policies are pumping extra cash into the economy, and that should be positive for growth.

Another positive highlighted by many is the fact that Japanese manufacturers, once viewed as having fallen behind rival producers amongst its Asian peers, are once again in the vanguard of technological progress, with its companies being amongst the leaders in the fast-growing world of robotics.

Abe has changed the mandate of the country’s giant pension fund to ensure that a greater proportion will be deployed to local equities, instead of bonds, and so boost the market.

In addition, the Japanese central bank has announced that it will no longer tolerate its bonds trading at negative yields. This implies that Japanese inflation will be allowed to rise, which is good for equities and bad for bonds.

So the combination of all of these factors means that the chatter in the bars and the bistros of the City has changed, and another old adage is being wheeled out – that, with Japan, it really might be ‘different this time’.

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