Value to be found as Japan faces up to its demons

The two weeks to the mid-November were frantic for Shinzo Abe, Japan’s prime minister. On 18 November, Mr Abe called a snap election two years ahead of schedule to seek a new mandate to push back a scheduled consumption tax increase, gambling his political future in a bid to win public support to continue to press ahead with ‘Abenomics’.

His ambitious plan to revive the stagnant economy – through the ‘three arrows’ of ultra-loose fiscal stimulus, monetary easing and structural reforms – received a blow when preliminary data on the third quarter GDP indicated the country had slipped back into technical recession, its fourth since the financial crisis. The economy shrank 1.6 per cent quarter-quarter on an annualised basis, versus analysts’ expectation of 2.2 per cent growth, as Japan struggles to shake off demand-sapping effects of the first increases in consumption tax in 17 years, which took effect in April.

Also, the tax rise worked against one of the main goals of Abenomics, which is to raise the inflation target to a sustained 2 per cent a year and shatter the deflationary mindset that has plagued the corporate and consumer sectors for the past two decades.

“Delaying the sales tax hike is good economics and calling a snap election for next month is good politics,” comments James Dowey, chief economist at Neptune Investment Management. “This will prove to be very positive for Japanese equities.” It makes sense to get the inflation job done first and then hike taxes, given the effect of delaying the hike on fiscal sustainability is very small, he says. Politically, this is also a good moment for Mr Abe to consolidate power, over an opposition party in disarray.

With a debt now twice the size of its GDP, Japan is “walking on thin ice”, notes Didier Duret, CIO, ABN Amro Private Banking, arguing however the timing of the tax increase may not be right. A country should try and gain economic momentum first and then address the debt problem, he says, taking the US economy as an example.

Other recent developments have led investors to monitor the world’s third largest economy closely.

At the end of October, Haruhiko Kuroda, Mr Abe’s radical appointee as the Bank of Japan’s governor, announced a dramatic increase of its quantitative easing, aimed a sustaining the “momentum of inflation” promising to purchase JPY80tn (Ä54tn) of Japanese Government Bonds, an increase of JPY30tn a year, along with increased purchases of ETFs and Japanese real estate investment trusts (Reits).

On the same day, Japan’s largest government pension investment fund announced it would more than double its allocation to domestic equities, a move that could be emulated by other pension funds, potentially adding even more liquidity to the market. Individual investors too may be encouraged to invest more of their savings into risk assets.

These new developments will have a positive impact on the economy and stockmarket, believes Mr Duret, explaining the bank has had a neutral weight on Japanese equities since January 2013. The Dutch institution favours exporters, companies in the automation, car and auto part sectors, and to an extent the pharma sector. Japanese Reits, which generate an attractive yield versus the Japanese government bonds are also appealing.

The recent move from the BOJ has driven Paul Lambert, head of currency at Insight Investment to increase his short position on the yen, as the divergence between US and Japanese monetary policy becomes clearer, also believing that the BOJ will take more action in the future. He points out that real economic growth is a function of productivity, labour force and space capacity, but productivity in Japan is already relatively high, there is little spare capacity and the labour force is set to shrink over the long term due to an ageing population. “Generating growth will be very challenging,” he warns.

A very positive perspective on Japan comes from Société Générale. “The Japanese structural reform is very complex, very detailed, almost like a micro rather than a macro programme,” says Alan Mudie, head of investment strategy for Société Générale Private Banking and CIO of SGPB Switzerland. None of these initiatives taken individually are game changers for the Japanese economy, it is the sum of them all that will make a difference, he explains.

He sees the return of positive levels of inflation and wage increases as very beneficial to the economy and consumer spending. The recent changes to the quantitative and qualitative easing programme announced by Mr Koroda and the shift in the asset allocation for the government pension fund are going to be supportive factors for the demand for equity securities. The weakening yen will provide both imported inflation, export competitivity and enhancement to earnings through the repatriation of foreign earnings in stronger currencies back into yen.

“On many measures, Japan scores as one of the cheapest markets globally,” says Mr Mudie. The outlook for earnings growth is better than elsewhere this year and will remain strong in 2015, with the bank predicting around 8 to 10 per cent increase in earnings for next year.

The large cap high technology companies are probably the most attractive because of both the impact of stronger global demand and a more competitive exchange rate. Also Japan is well positioned in a number of transformations currently under way in technology, for example the country is a clear global leader in robotics.

“Those mid to larger size companies have the position in market to benefit from the demand for robots in both manufacturing but also increasingly in services,” says Mr Mudie.

Exporters, even the bad ones, have benefited from the big yen depreciation. But the yen is not going to weaken into perpetuity, says David Vickers, senior portfolio manager, multi-asset growth strategy at Russell Investments.

“If you believe that structurally inflation is gaining traction, companies that have lasting fundamental value are banks, insurers, consumer staples, retailers and generally domestic orientated companies that can benefit from secular trends.”

Japan still suffers from structural issues, for example labour mobility needs to improved, and womens’ participation in the workforce increased. Corporate taxes are high, although the prime minister has promised to reduce them. Corporates also need to improve their governance. Many have a lot of cash in their balance sheets, but have been slow to pay dividends. Some of the companies invest unprofitably, perhaps for social good, but keeping people employed in an unproductive capacity is bad for economics, shareholders and the general economy, says Mr Vickers.

“The major risk for Japan is that inflation does not come through, that people think that inflation is not going up and in that case it won’t go up. People have the power to stop spending money, and if they don’t spend money, demand falls, supply increases and prices will come back down again and the Abe experiment will have failed,” he says.

The corporate sector in Japan is very healthy and offers attractive investment opportunities, not just in the short term for quick profits but also in the medium to long term,  believes Ernst Glanzmann, fund manager of the JB Japan Stock Fund at Swiss & Global.

The Japanese equity market is known to have high PE ratios, but over the years they have decreased to level which is today below that of European stocks, for the first time in 30 to 40 years. But Japanese corporate earnings have been growing at a compound annual rate of more than 10 per cent, like their US counterparts, he says.

Investors wrongly focus on political developments or the macro-economic situation, but a bottom-up approach is much more appropriate, says Mr Glanzmann. Japanese firms are less and less reliant on the domestic market, and giants such as automotive manufacturer Toyota or air conditioning firm Daikin have set up local production overseas, to grab new market opportunities in Asia or Europe.

This structural shift impacts export statistics, which partly explains why national accounts seem on a sluggish path, while the income statements of the corporates listed on the exchange are on a very dynamic path, he says, warning against a top-down approach.

Firms with international exposure are market leaders such as Nidek in the mini motor industry or Sizemax, the medical testing equipment maker. Those that focus on domestic consumption, especially in the consumer sector, need to adapt their business models and production to cater to ageing population, and many are already doing it.

Including Japanese stocks in clients’ portfolios adds value over the years, states Mr Glanzmann, claiming the selected 23 Japanese leaders in his fund have returned 91 per cent since July 2008, versus 16 per cent of the MSCI Japan ETF.

One of the major risks to the equity stock market could be an earthquake, Mr Glanzmann believes. “Also, the other biggest risk is recession, which can have a lasting type of impact on the business model, as some companies may be less flexible in adapting, and could incur heavy losses.”

An increase in corporate taxes would be bad, as would be too high a wage increase, as it would feed through profits.

Provided these major risks do not occur, Swiss & Global expects a compound annual growth rate of 10 per cent or more in profits for Japanese corporates, which should translate in similar annual appreciation in share prices.