Japan: building momentum – is this time different?

Tristan Hanson, head of asset allocation at Ashburton Investments  recently attended the CLSA Japan Forum in Tokyo where a number of companies and keynote speakers presented, including Prime Minister Abe, as well as meeting journalists, analysts and economists. He returned with the following conclusions:

1. The Japanese equity market looks relatively attractive for the next 18-24 months (the next consumption tax hike is scheduled for April 2017). Growth in earnings and dividends per share should be solid (positive economic momentum, tax cuts, shareholder-friendly initiatives); while the market’s valuation is underpinned by low yields in fixed income, persistent equity buying by the central bank and domestic pension funds and improving confidence in reflation (‘animal spirits’).
2. My market conclusions do not factor in any benefit from many other structural reforms contained within ‘Abenomics’; for example, (i) agricultural reform, (ii) TPP completion, (iii) electricity deregulation, (iv) health care reform, (v) National Strategic Special Zones, (vi) attracting more FDI from overseas, or (viii) encouraging foreign labour.
3. Female participation in the labour force, another focus of reform, is already increasing (probably more a response to tight labour market conditions than government initiatives but proactive measures may help). Tourism is booming and arrivals are up nearly 30% year-on-year (up over 80% from China), probably the result of the weak yen and growing demand for tourism across Asia, but the government has also eased visa requirements.
4. Some have become increasingly sceptical of ‘Abenomics’ following a disappointing outcome for GDP growth and inflation in 2014 after the consumption tax hike. However, the underlying momentum in the economy is improving. The effect of monetary reflation and a weak yen has not yet been fully passed through from profits to the wider economy, but it is starting. During 2012-2016, Japan is likely to achieve the first multi-year period of growth in nominal GDP since the mid-1990s. (Low growth, but a significant improvement nonetheless).
5. The prime commercial property market is tightening as vacancy rates fall. Office prices have rebounded as monetary reflation, rising profits and growing confidence bring down capitalisation rates. Rents are rising, as are construction costs as the market tightens.
6. Companies look set to respond to pressure from Abe’s government. Workers are likely to share in the profits rebound from an increase in wages. The labour market is tight in any case. Government pressure has also focused attention on shareholder returns and improved corporate governance. Every company that presented this week emphasised RoE and dividend payouts.
7. There is mixed response to the Bank of Japan’s (BOJ) decision last October to step up QE purchases. Some are concerned that further yen weakness is unhelpful; others worry that liquidity in the Japanese Government Bond (JGB) market has dried up. Given inflation seems certain to undershoot the BoJ’s target, further stimulus is very possible. The BoJ have said they are ready to do more. It seems plausible that further additional purchases may focus on equities and Real Estate Investment Trusts (REITs), but we cannot be certain of further action or what form it might take.
8. The direction of the yen is therefore now less clear and may depend more on events elsewhere in the US than in Japan. Our existing base case of moderate further depreciation against the US dollar seems reasonable, although we have to recognise the yen has already fallen back to 1973 levels on a real exchange rate basis and it is plausible that the BoJ disappoints those hoping for further very aggressive policy moves.
9. It is worth remembering that long-term nominal GDP growth in Japan is likely to be very low given demographics and continued efforts to reduce public debt, even if nominal growth turns positive on a sustained basis for the first time in 20 years. Depending on the success of Prime Minister Abe and BoJ Governor Kuroda’s efforts, a long-run annualised nominal GDP growth rate somewhere between a pessimistic 0.5% and optimistic 2.5% (suggested range: 0%-1% real growth and 0.5%-1.5% GDP deflator ). Sceptics may place themselves at the low end of this range; reform optimists at the top. I would think somewhere in the middle is a reasonable best guess. There are risks in both directions to this range. Complete failure would be a return to recent history of 0% nominal GDP growth. Note that corporate profits growth should be higher than Japanese nominal GDP given faster overseas economic growth.
10. On a broader note, I sensed a great desire for ‘Abenomics’ to work. The Prime Minister is extremely popular and it seems big business is happy to back him. Japan should enjoy a period of political stability from now until 2018 when Abe’s term ends, marking a sharp contrast with the previous merry-go-round of Prime Ministers. There is excitement ahead of the 2020 Olympics, perhaps another small reason for renewed optimism in the national psyche.

Of course, there are risks to this view – there always are. Among them, an external economic shock or a political event that disrupts the Abe-Kuroda show would be my main concerns. Pre-emptive fiscal tightening or a serious shock to the JGB market are among others, but I think unlikely in the near term.

The Japanese market is trading on a forward P/E, P/B and dividend yield of 14.4x, 1.4x and 1.7%, compared to the global average of 16.6x, 2.2x and 2.7% (consensus numbers, Source: JP Morgan). Japanese equity valuations are therefore not particularly depressed, but they remain below the world index on a P/E and P/B basis.

The market has been experiencing the best earnings estimate revisions of all the major markets (only market consistently positive) and I expect robust earnings growth to continue for the next 18-24 months. It is worth remembering that Japanese profits have historically shown among the highest operating leverage to the global economic cycle. A positive view is therefore predicated more on the outlook for fundamentals than it is a valuation-driven re-rating (although I think valuations are reasonable).

After a 25-year bear market, there is always a fear that any rally in Japan will subsequently collapse. But cyclical bull/bear markets have been a feature of other developed markets too over the past 15 years since the 2000 peak. Japan’s promising Koizumi period was torpedoed by the 2008 global financial crisis and the country also had to deal with the catastrophic 2011 tsunami/nuclear tragedy. I do not think the risks to Japanese equities are any higher (probably lower) than in other regions, despite their strong performance since late 2012.

In our Global Equity and Multi Asset Funds we retain an overweight position in Japanese equities. For the Multi Asset Funds, the exposure is nearly fully hedged; whereas in the Global Equity Fund, exposure is roughly 50% hedged reflecting an unhedged benchmark.

Notes

1. Net export volumes have been slow to pick up despite the yen’s considerable depreciation as many exporters ‘price to market’, in other words price their goods in the currency of the importing country. This results, initially, in little market share gain in volume terms in response to a devaluation (since the USD price of the Japanese export changes very little in response to JPY weakness), but considerable benefit to profits.

2. Note Japan’s GDP deflator has tended to be much lower than CPI inflation.