The Japanese stock market has been largely ignored by investors for the past two decades, given its long-term decline and apparently poor economic prospects since the bubble burst in the late 1980s. Starting in late 2012, the tide began to change.
Japan: A spring awakening?
Japan's economic struggles for the past two decades are well documented, with a number of events causing the Japanese stock market to be an unattractive investment market:
- Japan has been suffering anemic growth since the late 1980s.
- Consumer prices have been falling for more than 10 years.
- The government debt/GDP ratio, at 245%, is easily the highest in the developed world.
However, Prime Minister Shinzo Abe and new Bank of Japan Governor Haruhiko Kuroda have taken drastic measures through unprecedented monetary easing to curtail these long-standing economic issues, including doubling Japan's monetary base in just two years, in an all-out attempt to raise expectations for growth, inflation and asset prices.
Unlike previous attempts to implement change, the Japanese population is now willing to support higher inflation and a weaker yen as a matter of national interest. This support has been reinforced by Mr. Abe's Liberal Democrats subsequently winning the majority they needed in the upper house elections on July 21, thereby taking control of both houses and giving him the mandate needed for deeper reform.
In addition, Mr. Abe set a formal inflation target of 2% by 2015. Increasing inflation expectations is critical for Japan to lift itself out of the doldrums of deflation as deflation can result in a) people and companies hoarding cash — why spend now if prices are cheaper later?; b) companies cutting costs and wages to stay competitive; and c) people and companies afraid to borrow, irrespective of low interest rates, as the real cost of borrowing increases over time in a deflationary environment.
Generally, higher inflation expectations and looser monetary policy lead to a weakening currency. Unsurprisingly, we have witnessed a significant fall in the yen against the U.S. dollar since Mr. Abe came into power.
- Japanese exporters are the most obvious beneficiaries of this currency move as it makes the prices of their goods significantly more attractive to overseas buyers. The opposite can be said for Japanese companies that have inputs that are imported. Understanding the impact of this huge currency shift across companies clearly creates opportunities for managers using a long/short strategy. We have also seen managers shorting companies in places like Korea and Europe, where businesses are being adversely impacted by the resurgence of Japanese competitors.
- Japanese corporations, having suffered for years with a strong yen and somewhat sticky wages, have been forced to become more efficient and cut costs, including labor costs, to survive. For companies that have managed to do so, the pickup in business is leading to a very sharp uptick in profitability. One of our managers believes corporate profit margins in Japan could feasibly double, returning to levels not seen since before the global financial crisis.
- Domestic consumption companies are also expected to benefit from a long-awaited pickup in spending by the typically cash hoarding Japanese consumer. Evidence suggests Mr. Abe's policies already have lifted consumption spirits in Japan. Nonetheless, a sustained period of price increases and wage growth likely will be required to change consumers' deflationary mindset fully and to broaden consumption growth to less luxurious segments of the economy.
As can be seen from Japan's recent equity market rally, so far these measures have been received positively by global investors who have been underweight Japan for years. Foreign investor fund flows into Japan equities in 2013 have been meaningful and trading volumes have nearly doubled in the past six months.
Given the speed of this change, many investment managers are just starting to get their Japan research shoes on again. This speed of change in expectations is also evident in the chart below, with sell-side analysts scrambling to upgrade earnings forecasts to account for the changing economic conditions. In discussions with our Japan-focused managers, we are hearing about potential earnings growth of 50% or more for some of their long positions in 2013. Talk of this level of growth is typically reserved for conversations about stocks in emerging markets.
Although these drastic policy moves to date are being very well received, Japan is by no means out of the woods yet and there remain numerous longer-term risks.
- As one of our Japan managers noted, “the worry about how the Fed will exit its QE program is nothing compared to Japan.”
- Increasing inflation expectations are generally accompanied by an increase in long-term interest rates. This eventually has to be reflected in long-term bond yields, which in turn will reignite concerns over the sustainability of Japan's debt burden.
- There remains a huge structural problem in Japan with a declining workforce. Japan's primary consumers are its working-age people and this population segment has fallen every year since 1995.
- It remains to be seen whether countries like China and Korea, whose exporting companies compete with Japan, will simply stand by as Japan effectively devalues its currency and takes away some of their growth.
- The effectiveness of company management in Japan is another area with significant ongoing issues. For years we have heard from our managers that Japanese management teams do not always run their companies in the interests of shareholders. This mind-set does not change overnight.
We believe structural reforms within both the economy and at the micro level within corporate Japan will be critical to maintain momentum in this market and achieve longer term economic growth objectives. This so-called “third arrow” of Mr. Abe's reforms has to date been talk about targets and objectives rather than hard details about how they will be achieved. Investors soon will demand to see clearer evidence of real policies being announced and implemented and the hope is that the fresh victory in the upper house elections will provide that platform.
Christopher Ayton is a partner and portfolio manager at Alternative Investment Group.