After two lost decades, the Nikkei 225 index's surge of more than 50% since November caught the attention of investors.
They might be wondering whether Japanese equities are finally pulling out of a nearly 25-year bear market. Or was this rapid move in the equity market simply a flash in the pan brought about by the sharp 20% depreciation in the yen? Volatility in past weeks has raised further questions about the sustainability of the equity market rally.
Despite the currency move and recent volatility in the market, we might continue to see investment opportunities in Japanese equities driven by a sea change in the economic and political backdrop. Beyond the yen weakness, which has captured most of the headlines and helped to make the corporate sector even more competitive, the policies put forward by the new Liberal Democratic Party administration will be vital to sustaining the upward move in equities.
Since replacing the Democratic Party of Japan in December, the administration of LDP Prime Minister Shinzo Abe has announced a slate of measures designed to ignite an economic recovery and pull Japan out of its deflationary spiral. Until very recently, there was abundant disbelief that these policies would be effective if they were implemented. My response to such skepticism has been that when Japan is attempting to climb from such a large economic policy void, even the magnitude of change doesn't have to be extreme to have a healthy impact on the economy and the equity market.
In the upcoming months, the government will introduce a variety of legislative initiatives. If these policies are successful, 2014 nominal gross domestic product growth could be above growth in Europe and even the United States, which would likely spur continued outperformance in Japanese equities vs. other developed markets. The “three arrows” of Mr. Abe's plan for economic stimulus are monetary policy, fiscal policy and structural growth strategies.
Steps toward the implementation of bold monetary policy and flexible fiscal policy — two of these arrows — already have been taken. These efforts will enhance corporate value, and changes in earnings power should continue to support the equity market.
Before the recent weakness in the yen, the currency had experienced a multiyear strengthening trend. As the recent rapid depreciation has coincided with strong equity market performance, the weak yen has been portrayed as the only good thing happening for corporate earnings in Japan. There is reason to disagree with this premise. While the weak yen might finally allow Japanese companies some breathing room to grow, the strong yen probably was one of the best things for Japan's corporate sector. In recent years, Japanese companies have gone to great lengths to remain competitive. The increased efficiency of Japanese corporations has led to a decline in the break-even level of the yen at which businesses can profitably export — with the translation effects alone resulting in ample upside to profitability. The weak yen now increases Japanese competitiveness disproportionately and might allow Japanese companies to gain market share vs. their global competitors.
For years, many observers have pointed to the structural obstacles impeding Japan's economy and, by extension, the equity market. Aging demographics, the soaring debt-to-GDP ratio, ongoing deflation and a stagnant corporate sector are among the most frequently cited.
Such structural issues will not be solved overnight, but a new government with clear and positive policy initiatives can help.
Here are some ways that could happen:
nWith regard to the headwind of aging demographics, measures such as labor deregulation, child-care reform and a rising retirement age could allow for a more fluid and better-used workforce.
nThe high debt-to-GDP ratio has been the focus of investment bears, but the country could avoid falling into a classic debt trap. The government's broad asset base — both on- and off-balance sheet — has the potential to serve as a “fourth arrow” to restructure and thus mitigate Japan's debt burden.
nReversing chronic deflation is a main goal for fiscal and monetary policy. Even if the 2% inflation target is not hit in two years as planned, these policies could make significant strides toward that goal.
The historical stereotype of a stagnant corporate sector is beginning to change as Japanese companies have tackled head on the problems of deflation, a strong yen and the financial crisis. Ardent Japan watchers have been aware of this for years, but the markets are only now starting to recognize the transformation.
To overcome these and other obstacles to economic growth, a number of policy levers could still be pulled in Japan, and the LDP government has just begun to pull them.
After the robust rally in Japan's stock market and subsequent pullback, investors might be wondering, what's next? The Japanese have spent more than two decades in economic and equity market malaise following the excess of the asset bubble of the late 1980s.
This might not be just another bear market rally along the lines of 1993, 1999 and 2003, but the beginning of a new era for Japan. Asset prices, including real estate, have normalized. Stock market valuations, which peaked at very high levels, have corrected. Japanese corporations, with excessive cost bases, have restructured. And around the world — from the retail investor in Japan to the global investor in San Francisco — equity investors are generally underweight Japan.
While we already have seen a handsome rise in Japanese stocks in the past few months, I argue the positive changes in Japanese politics and their effects on the equity market have just begun. n
Eileen Dibb is a Smithfield, R.I.-based portfolio manager at Pyramis Global Advisors, a Fidelity Investments company. She also is co-manager of Fidelity Asia Star Fund, a mutual fund distributed in Canada.