It is a well-known saying in the investment community that Japanese equities should be occasionally rented, but never owned. Are there any reasons to believe the current market rally is different? Dramatic changes are now taking place in Japan. What we are witnessing is a very real opportunity for Japan to break out from the economic and political stagnation that it has endured over the past two decades.
For many years the asset allocation of pension funds and other institutional investors has had a strategic underweight position to Japan. This has been justified by thinking about the reduced relative gross domestic product/market capitalization weight of Japan compared to where it was in 1990 and to the other large developed equity markets. From an asset/liability point of view, pension funds and their advisers would point to the long run return profile and say that according to their models the expected return from Japan equities will be below that of — well, everywhere else.
This has arguably been a good strategy for years, but now Japan is taking off and while we have definitely witnessed increased interest from institutional investors, there is also no doubt that some of them will be caught napping.
So what are the reasons for this newfound confidence in Japan?
There is a new pro-business government and the country is ready for change. Various factors combined to bring about the rally — such as the calming of the euro crisis, the bottoming out of the Chinese economy and a pickup in the U.S. housing market, But the election of Shinzo Abe's Liberal Democratic Party in mid-December was clearly crucial for the turnaround in sentiment. Indeed, the yen started weakening and equities rallied as soon as prospects for a new government and new policies started brewing last summer. Since October, the expectation of aggressive policy action on both the monetary and fiscal side, associated with the advent of “Abe-nomics,” has sent the yen tumbling nearly 16% against the U.S. dollar and the stock market soaring nearly a third.
The appetite for change in Japan is extremely strong, especially following the anti-Japan riots in China. Indeed Mr. Abe's approval ratings have shot up since the election and he is widely expected to win the Upper House election in July. If that happens, there will not be another election for three years.
There is a landmark, once-in-a-generation change in the Bank of Japan leadership and a new policy accord. For the past 15 years, the Bank of Japan has been under a hawkish, anti-business leadership. The recently announced early retirement of BoJ Governor Masaaki Shirakawa, however, will speed up his already planned replacement with a more dovish successor. BoJ's new leadership will share the government's pro-business stance and will remain at the helm for a full five-year term, helping to ensure policies are implemented. Crucially, the common ground extends to a shared view of how to achieve sustainable economic expansion. In particular, there is agreement that expansionary monetary policy should be combined with fiscal stimulus to reflate the economy, and measures to tackle Japan's various structural problems, such as persistent deflation, must be implemented at the same time.
Abe-nomics is a catalyst for sustained economic expansion and equity market recovery. Abe-nomics comprises three key elements: aggressive monetary stimulus, including raising the BoJ's inflation target to 2%; fiscal stimulus in the form of public works spending; and, longer term, a program of structural reforms to boost sustainable growth potential. Providing the government continues along the path of reform, the positive feedback mechanism between the real economy and the stock market should ensure that both economic and market expansion are sustained.
Another significant breakthrough is that deflation appears to be coming to an end. Wholesale prices, including imports, are now up 1.4% after falling 2.2% last summer. This is the first reading above 1% since the 2008 crisis. Inflationary expectations are also rising, although the consumer price index is likely to be capped at 1% for the next 18 months, which along with large BoJ purchases, will help support Japanese government bonds prices.
The benefits of the weaker yen are clear. Near-term earnings forecasts by major Japanese exporters were based on exchange-rate levels that were around 20% higher than the current rate. More importantly, in the longer term a sustained weaker yen will have a positive impact on corporate activities, such as encouraging strategic investment associated with healthier attitudes toward risk by company management. These long-term benefits will be a key driver of Japan's recovery.
It is still early days. The implementation of Japan's structural reforms is clearly dependent on the LDP's victory in the Upper House elections in July and institutional investors will watch this event closely. A number of issues facing Japanese manufacturers must be decisively addressed, such as high corporate tax rates, restrictive labor laws, high energy costs, excessively strict environmental regulations and slow free-trade agreement negotiations. The yen's sustained weakness also remains crucial to progress. Providing the government continues to address these “headwinds,” institutional investors should continue to reward Japanese equities with a sustained re-rating, meaning a higher valuation. Beyond the rally are clear foundations for a sustained bull market. Japan's corporate governance has seen a significant improvement which has manifested itself in many guises, such as continued increases in dividend payout ratios, which are now comparable to levels seen in the U.S. market. However this improvement has so far been overshadowed by Japan's various crises and isolated governance scandals and, as a result, has been overlooked by institutional investors. The Japanese corporate sector might not be reaching Western-type shareholder rewards any time soon, but it does offer very healthy corporate earnings and operating margins, underpinned by robust business models, competitive products and resilient demand. These factors, which have been in place for some time, will now combine with positive economic and political developments to help transform the recent surge in sentiment into a sustainable bull market trend.
Charlie Metcalfe is president of Nikko Asset Management Europe Ltd., London.