Since late 2012, coinciding with the election of reformist Prime Minister Shinzo Abe, Japanese equity markets have surged nearly 70% (in local currency). Yet “Abenomics,” as the set of ambitious and bold fiscal and monetary policies pursued by the Abe Administration have been dubbed, have thus far failed to move the appetites of Japanese household savings. But there is reason to believe that Japan is on the precipice of reordering its domestic savings structure as soon as this year, with potentially significant implications for its equity markets.
The big structural upside in Japanese equities
Abenomics, including its much discussed “three arrows” and ambitious goals of breaking Japan's 15-year deflationary cycle and 25-year economic funk, have been much discussed and analyzed elsewhere. In particular, the potential implications for corporate earnings and stock prices from ending deflation, improving corporate governance and depreciating the yen, among other major changes in Japan's macroeconomic outlook, are probably well understood and perhaps priced into the Japanese market already. In that regard, lower oil prices are merely just another wonderful gift for the Japanese economy. These aforementioned factors guide what might be labeled as “discretionary demand” for equities. This includes investors (Japanese and global) with geographically agnostic mandates, including hedge funds, as well as other more nimble investors.
Japanese equities have also received a substantial boost from a new “structural demand,” particularly from the Japanese central bank and government pension funds. On Oct. 31, the Bank of Japan and the Japanese Government Pension Investment Fund together announced they would each substantially increase their asset purchases of Japanese equities. The BOJ said it would triple its purchases of exchange-traded funds to 3 trillion yen annually ($24.8 billion), while the GPIF, which has about $1.3 trillion in assets and is the world's largest employee pension fund in the world, announced that it would double its total equity allocation from 24% to 50% (12% to 25% in Japanese equities). Together these portended future inflows of about $195 billion in new “structural demand” for Japanese equities over the coming year. Understandably, markets reacted strongly, with the Topix soaring 4.3% on very heavy volume in just one day. Perhaps without coincidence, $195 billion is nearly equivalent to 4.3% of the market cap of the Tokyo Stock Exchange ($4.5 trillion). Meanwhile, EPFR data indicate that through the first 11 months of 2014 (i.e. capturing the big boost to markets from the BOJ/GPIF announcements at the end of October) fund flows into Japanese equities totaled a mere $12 billion. Thus, it seems that most of the buying at the end of October was not driven by retail, but institutional or other discretionary buyers who efficiently priced in the BOJ and GPIF announcements into market prices. This leaves open the possibility that Japanese retail investors may still shift their own structural demand for Japanese equities.
Japanese household savings currently are substantially more conservatively allocated than their American or European peers, with an amazing 53.1% held in cash. But this difference is not proportional to the difference in age distribution between these markets, thus reflecting a structural bias unique to Japan vis a vis its developed peers. For example, the percentage of the population age 65 or older is 24% in Japan, 19% in Europe, and 14% in the U.S. However, the average allocation to cash in the U.S. and Europe was 13% and 34%, respectively, vs. 53% in Japan. This allocation percentage has been consistently high over the past 25 years, ranging from a low of 44% in 1989 to a high of 54.5% in 2009. The variance in the allocation to cash has come almost entirely in line with equity market performance, further indicating no meaningful allocation changes from Japanese savers during this time, even during the bull markets of 1999-'01 or 2004-'07. Thus it would probably take an environment that is substantially different from the past 25 years to nudge Japanese savers into a more aggressive investment posture. Yet, that is arguably exactly the environment Japan presently finds itself with the overwhelming re-election of Shinzo Abe's coalition in the December elections.
If Japanese household savings were to rise from their current levels to mere European area levels of equity exposure, that would be an additional $1.1 trillion to flow into equity markets. Should Japanese households return to their peak exposure to equities in 1989 (23.4%), that would top up the market by an estimated $1.5 trillion. If only half of this were to flow into Japanese equities (a very conservative estimate given the currency weakness and general tendencies of national savers to keep most of their assets at home), that would be equal to about 16.7% of the present Japanese stock market. Moreover, as past trends indicate, any allocative change in savers' accounts will almost certainly come at the expense of cash and savings account deposits and not bonds or other risk assets. Thus, this would be a gain in the markets net of any other asset class (except perhaps the value of the currency if a significant percentage of new equity purchases are in unhedged foreign shares).
So far, however, Japanese retail investors have been slow to change the allocations of their savings. The recent introduction of Nippon Individual Savings Accounts, or Nisas, modeled on the Individual Savings Account program in Britain, has been slow to gain traction in the Japanese market. But in an aging society such as Japan, this should not be a surprise. Older investors may be prone to a more deliberate decision-making process and also less inclined towards incurring undue risk in a portfolio that is shorter term in nature. However, the Abe administration is reportedly planning on launching a “junior Nisa,” in which parents and grandparents can set up an account for children who are 20 or younger with an annual limit of 800,000 yen (about $6,600). Many observers expect this to be a much more substantial catalyst to the retail market. “Of all the measures out there, the junior Nisa will have the biggest impact in terms of scale,” said Takashi Hibino, chief executive of Daiwa Securities Group. “This will allow the Nisa system to become permanent.”
Meanwhile, a set of younger, longer-term investors may be undeterred by the relatively lower liquidity or higher volatility and attracted by the favorable valuations offered by smaller cap Japanese companies with their net cash position and improving earnings environment. Meanwhile for foreign investors, the consensus trade of long Japanese equities and short the yen appears to remain the most sensible route through at least the first half of 2015. But as broad allocative shifts of household savers is a slow process, there is a strong case for the structural upside to Japanese equities, small caps in particular, over the next 12 months to 24 months, regardless of one's views on the major macroeconomic issues of Japan which are not the direct subject of this paper. The high potential of a major shift in the “structural demand” for Japanese equities warrants a re-evaluation of longer-term investors' allocations to a market that has long been regarded in Western investment circles as a value trap.
Adam Choppin is a manager research product specialist at FIS Group Inc., and Tina Byles Williams is FIS Group's CIO & CEO.