Is Abenomics the right medicine for Japan’s ills?

Until the beginning of June, when the Nikkei index of leading Japanese stocks crashed by 6.4 per  cent in one trading session, the Tokyo market had been the top pick of all the leading private banks, spurred by a massive 50 per cent rally since the beginning of the year.

From its peak on May 22, the Nikkei 225 has plunged by 20 per cent, technically entering into a bear market for the first time since early 2011.

Swiss banks such as Julius Baer, for instance, which sees Asia as its second home market, recommended Japan to its clients as “one of the most exciting themes,” believing that ‘Abenomics’ – the new political will to combat deflation, based on measures championed by new Prime Minister Shinzo Abe – would provide a strong and lasting catalyst to the equity market.

It even recommended specific products, such as Polar Capital’s Japanese equity fund, as the ideal routes to gain market exposure.

Several weeks later, things have changed drastically among the banks, although to be fair to Baer, Asian chief investment officer Kenneth Ho talked about actually increasing exposure by “buying on dips in the market”, as long as a currency hedge was part of the package. It is refreshing for a leading bank to stick with the courage of its convictions. Many others, however, have been negative for some time.

Typical was Swiss rival Pictet, where Luca Paolini, chief strategist at the asset management division, began to tour distributors in major markets such as London to offer his opinions. Pictet is  underweight, believing Japanese equities are fully priced. “What we have seen is massive profit taking after an incredible rally,” says Mr Paolini.

Corporations, he admits, have been doing well because of the value of the yen, which has moved from being one of the most expensive currencies in the Swiss bank’s model to one of the cheapest.

Before Pictet commits any more client assets to such companies, Mr Paolini wants to see “real reforms” from the Bank of Japan. “Abe has been talking about breaking up regional monopolies of utilites, but we want to see the proof,” he says, adding that most of the movement originally expected by Swiss banks in Japanese equities has now already happened.

Those who did not invest seem to have missed the boat. “It is difficult to imagine a repeat of the returns we had for the past six months,” he says. “We want to see real structural reform for the Japanese market to be up there with other developed markets.”

Like  many other banks, Pictet has become cautious, taking a “wait and see approach” before buying Japan again, not expecting further depreciation of the yen, but rather seeking out other catalysts before entering the fray once more.

Amin Rajan, founder of the Create Consultancy and a regular visitor to Tokyo is similarly sceptical, calling “Abenomics” something of a “wild card”.

“It has a lot going for it and a lot against it,” he says. “It will succeed only if Japan avoids currency wars in Asia.”

While the recent pick-up in Japanese economic growth is a welcome development, it is not the main driver of markets, believes Mr Rajan. “The rise of Japanese stocks has been mainly fuelled by prospects of good corporate earnings on the back of exports,” he says. “Japan needs a cheap yen to fuel its markets.”

Yet this view is by no means shared by all observers. Jupiter’s Simon Somerville, who manages the group’s Japan Income fund, believes Abenomics is having a “real impact”.

“Abe is still very popular and Haruhiko Kuroda, the new governor of the Bank of Japan, is determined to achieve his goal of 2 per cent inflation,” says Mr Somerville. “The recent volatility in Japanese equities has made investing in Japan look risky, but in my  view, Japan still offers a real recovery story.”

Coutts also continues its positive view of Japan, although performance is nevertheless expected to lag behind economic fundamentals for a short period. “The government’s announcement of a reform and pro-growth programme and the Upper House election in July should give the market a stream of good news over the coming months,” says the bank’s Asian chief investment officer Gary Dugan.

Because the weaker yen will benefit companies with significant exposure to foreign revenues, Mr Dugan prefers exporters, industrial and car manufacturers in particular. He also expect the BoJ’s actions to support the banking sector, while the end of deflation could invigorate the housing market.

Japanese equities have always been highly volatile relative to other markets, he says, and in a historical context, a true bear market in Tokyo can only be called once a fall of 35 per cent has been recorded. “We think that it is very unlikely that the market would fall to this level,” he says, due partly to a more realistic price earnings multiple and evidence of growing sales.

On the political front, while the most recent instalment of the ‘Abenomics’ package, known as the ‘third arrow’ has been met with criticism due to its lack of clarity, Mr Dugan puts this down to a reluctance to touch “sacred cows” which can threaten to destabilise Mr Abe’s election prospects ahead of an Upper House vote on 21 July.

“We remain overweight on Japanese equities and see these corrections as buying opportunities,” he says, claiming Tokyo still appears attractive relative to other developed markets.

Asset manager Threadneedle is similarly positive. “There is no doubt the authorities mean business and intend to do whatever it takes to stimulate the economy and the liquidity taps are well and truly open,” says Mark Burgess, Threadneedle’s CIO.

Although the yen may have stopped weakening, possibly temporarily, it is now at a level where the economy looks competitive against its Asian counterparts, he says.

“We expect there to be a substantial improvement in Japanese profitability and earnings and think the equity market sell-off is an opportunity to increase our exposure,” says Mr Burgess, with plans for more purchases on further market weakness.

Increasing exposure

Although still cautious, EFG Asset Management has taken the opportunity to increase recommended allocations from underweight to neutral following the recent sell-off. However, this volatile asset is not for everyone, says chief economist Daniel Murray, who suggests currency hedges should be a pre-requisite for any exposure, believing future rallies are not sustainable without further yen weakness.

But at the end of the day there is marked scepticism about the concept of Abenomics. “There may be some short-term benefits associated with looser policy – both monetary and fiscal – and improved sentiment, but we believe that the structural headwinds are too great,” ventures Mr Murray.

Japan’s poor demographics are the country’s major hurdle, he says, coupled with additional problems of rigidities in labour markets and cultural differences in management practices. “These cannot be solved overnight,” he believes. “Any radical plans to address these structural problems will take a long time to implement and take effect,” with current proposed changes hard to enact and not going far enough. For these reasons, says Mr Murray, “we view Japanese equities as a trade not a trend”.

Abenomics is far from a quick fix, agrees Charlie Metcalfe, president of the European arm of Japanese house Nikko Asset Management, who says the correction followed “irrational exuberance” in the market.

Yet he expects the pace of reform to quicken as the July Upper House election consolidates the leadership of Mr Abe. He notes that the first two arrows of the package caused the economy to grow 4.1 per cent in the first quarter of 2013. “Vitally, inflation and a change in consumer spending patterns are already beginning to be felt,” says Mr Metcalfe.

“As a whole we expect that its effects will be deeply rooted into an additional change in the Japanese mind-set.”

As Nikko runs a suite of Japanese products including active equity, high dividend, quant and ETFs, it is understandably optimistic over the medium term, expecting inflation and market optimism to lift all Japan valuations and equity prices going forward.

But as a Japanese house steeped in the chequered history of false dawns rising above the Tokyo market over the last two decades, Nikko warns investors about getting carried away with the story.

“One risk is that they will react and over-react time and again to any news flow or nuance which either enhances or undermines their belief in the Japan story,” says Mr Metcalfe. “This has already happened in the recent rally and correction.”

There may be even more danger in ignoring the market, he says. “Some underweight investors are still sitting on their hands, hoping  this again is a false dawn and the underperformance they will be reporting soon to their clients will not be repeated in coming quarters.”

Many investors are so conditioned to seeing Japan as a lost cause that they are finding it hard to reduce the risk position they have in a “large short” or even go neutral. “This could become painful,” concludes Mr Metcalfe.