J-Money: Why Investors are Turning Positive on Japanese Equities

J-Money, April 2015

Lately, international investors have started to turn increasingly positive on Japanese equities. Partly, it’s a question of value, and partly, of faith in reform, but the pattern is becoming increasingly widespread.

An example is Baring Asset Management, which is looking afresh at Japan after several years of outperformance by US stocks. “Barings believes investors should be looking elsewhere [than the US] to identify markets which are supported by a competitively weak currency and by more stimulative monetary policies,” says Marino Valensise, head of Barings’ global multi-asset group, and chairman of its strategic policy group. “One such opportunity exists in Japan.”

Why? It’s a combination of factors. “In terms of monetary policy, the country remains extremely accommodative – quantitative easing and corporate governance improvements will continue to stimulate exports via a weak currency and to support corporate profitability,” Valensise says. “Earnings growth expectations are approximately 12%, and there have been several positive earnings revisions since mid-2014.”

Others have formed a similar conclusion. Vadim Zlotnikov, chief market strategist and co-head of multi-asset solutions at AB (AllianceBernstein), holds an overweight position on Japanese equities. It’s already working, he notes, with Japan and Europe outperforming the US by about 2% in February, and Japan ahead of the US by about 5% for the year to date by late March.

As with Barings, Zlotnikov’s view is not purely on Japan’s own fundamentals, but a matter of comparison with other world markets, particularly with currency in mind. “Currency devaluation is making European and Japanese equities more attractive, and we modestly prefer Japan based on valuation,” he says, favouring cyclical multinational companies in particular.

Japan, he notes, is the only region trading well below median valuations. “Even though the earnings of Japanese companies have roughly doubled since 2013, the market is only up 60%, which led to substantial compression in price to earnings ratios,” he says.

Zlotnikov also notes that Japanese currency and equity markets seem to have decoupled. “One interpretation is that the current economic outlook for Japan is becoming somewhat less dependent on currency stimulus and more reliant on improving sentiment, capital spending and bank lending,” he says. Zlotnikov is generally positive on Japan at a policy level, noting that the probability of structural labour reform is higher in Japan than, for example, Europe, which could lead to a higher valuation premium.

However, when international investors look at Japan purely on its own merits, rather than in comparison and on valuation grounds, they are not always so positive. Standard Life’s chief economist Jeremy Lawson looks at the potential in Japan’s corporate sector outside the banks, and wonders about their pace of investment, hoping to see investment spending increase as Japanese corporates have rebuilt their balance sheets during the period of monetary stimulus. “So far, the pace of change has been disappointing,” he says. “Corporate borrowing has picked up only modestly over the past two years and firms actually appear to be increasing their excess cash holdings.” Aggregate business investment has actually declined for three consecutive quarters, he notes, although this was partly because of the sales tax increase last year.

“Further out, Abe and Kuroda’s strategy to raise inflation expectations, while keeping short and long-term interest rates very low, is helping to lower the real effective borrowing costs of firms, which should eventually translate into stronger loan demand,” says Lawson. “The corporate governance changes that are underway should also encourage firms to use their balance sheets more efficiently, while the prospect of a lower corporate tax rate is also likely to stimulate more investment in domestic productive capacity.”

Those changes, though, will not be enough, Lawson says, because there are other structural barriers to growth. To be effective, the Abe government will need to accelerate the third arrow of reform, in particular labour market reform. “Corporate balance sheets may be the healthiest they have been in a generation, but unlocking firms’ potential requires radical changes to the incentives for putting those balance sheets to work,” he says.

A common view can be surmised from SEB’s investment outlook, published in March 2015, which headlined its section on Japan as follows: “Japan’s economy not good, but less bad.”

Noting that last year’s recession – triggered partly by the consumption tax hike in April 2014 – was Japan’s fourth in six years, SEB expects 1.1% growth in both 2015 and 2016, helped by higher exports to the US economy, a weaker yen, and further stimulus measures, as well as a benefit from a low oil price since Japan is a significant net importer of oil.

Like Lawson, SEB feels that only two of the arrows of Abenomics have fired, and that the third one will be needed in order to create long-term optimism about Japanese shares.  “The first and second arrows in Prime Minister Shinzo Abe’s Abenomics strategy – monetary and fiscal stimulus measures, respectively – have helped sustain Japanese growth and will continue to do so, but there is still great uncertainty about how much the third arrow, structural reforms, will contribute. The government has, however, taken steps to boost the share of women in the labour market and make it easier to recruit labour from abroad.”

Does Japan need a fourth arrow? In a report released in March, the consultancy McKinsey & Company suggested so. “A major private-sector initiative to transform Japan’s productivity performance can launch a fourth arrow of economic reform, complementing measures to boost growth through monetary policy, fiscal stimulus, and structural reform,” the reports authors – there are six of them – say. “Many of the barriers and bottlenecks that have constrained growth stem from traditional ways of doing business. Japan can reach some 50 to 70 per cent of its productivity goal simply by adopting practices that are already in use around the world. Much of the remaining improvement can be captured by deploying new technologies and business models.”

McKinsey argues that if Japan can double its rate of productivity increase, it could boost annual GDP growth to approximately 3%. “By 2025, Japan’s GDP would increase by up to 30 per cent over its current trajectory. The size of the prize would be growth of $1.4 trillion in that year alone.”

Before we reach those distant projections, it will be interesting to see how the US’s gradual normalization of interest rates – expected to begin later this year – affects Japan. Economists don’t feel it will particularly undermine interest in Japanese assets; there may be some capital flight from emerging markets but Japan, at least on the debt side, continues to be considered a safe haven. That status will only be helped by other geopolitical problems, from sanctions in Russia and the crisis in Ukraine, to ISIS in the Middle East and Europe’s problems with Greece. It is possible that any or all of these things could undermine global growth, both in an economic and stock market sense, but there’s certainly no reason to feel that Japan would suffer more than others – indeed, probably less.