For us in the Baring Global Multi Asset Group, Japan has been one of our larger positions for some time. In the fourth quarter of 2014 we increased our position further. So far, this theme has rewarded our conviction with the FTSE Japan up a healthy 15.9% in local currency terms in the first quarter of 2015.
So what do we like about Japan?
1) The natural cyclical recovery has been aided by a weakening yen, with the full benefit yet to be seen.
At the start of 2013, the Japanese economy was in the doldrums. The country was recovering from 2011’s devastating tsunami, and the outlook for the economy was poor. Market valuations reflected this sentiment.
In our view, this cyclical trough was due to be short-lived. The economic recovery in the United States and Europe would have a natural impact on Japanese prospects. The domestic situation and extreme pessimism would have eventually improved – a classic market opportunity.
But the election in 2012 of Shinzo Abe as prime minister accelerated and magnified the turnaround. His tools were the much-vaunted ‘three arrows’: fiscal stimulus, monetary stimulus and structural reform.
Of these, the most important by far is monetary stimulus. Under the newly appointed Haruhiko Kuroda as governor, the Bank of Japan launched a policy of quantitative and qualitative monetary easing in 2013, which was expanded in 2014.
This version of quantitative easing is more radical than that done by the US Federal Reserve, the Bank of England or even the European Central Bank, since the qualitative part means that the Bank of Japan not only buys government bonds, but also exchange-traded funds and real estate investment trusts. This huge stimulus caused the Japanese yen to weaken by around 50% versus the US dollar.
This has naturally had a positive impact on Japanese earnings due to a simple currency translation effect. But the real benefit comes later. It takes time for corporates to react to a weaker currency and reposition their businesses. Typically it takes two years or more for a weaker currency to lead to greater market share. Thus the slow improvement in Japanese exports is not something to be disappointed by, as the bears would argue, but an indicator of the improvement yet to come.
This combination of a cyclical recovery, the currency translation effect and the early stages of market share gains has meant the Japanese market has recently seen continual upward earnings revisions. We think there is still more to come as export growth becomes more established.
2) Structural and corporate governance reforms
While Japan has recently implemented modest supply side reforms, such as the establishment of special economic zones which include Tokyo, of more interest is the attitude shift taking place around corporate governance.
The most notable change is the introduction of a new equity index – the JPX-Nikkei 400. Produced by the Tokyo Stock Exchange (TSE) at the government’s urging, this index is an official compilation of the 400 best listed Japanese companies in terms of corporate governance.
The TSE details the methodology it uses. It looks at the number of independent directors, the degree of cross-holdings and the return on capital. All of these metrics are powerful indicators of shareholder returns, and thus improvement in behaviour can swiftly reward stockholders. Equally important to change corporate behaviour, the same methodology is also intended to expose the companies who sit at the bottom of the corporate governance scale – the so called ‘shame index’.
Such a public naming of the best and worst companies is likely to succeed in Japan where the foreign activist hedge funds failed. Already the domestic media coverage around the introduction of the JPX-Nikkei 400 and the scramble of companies trying to make it into the index is evidence of change.
3) GPIF share purchases
While the ‘shame index’ serves as a powerful stick to encourage corporate change, the Japanese government is also providing a carrot, by making the index the target of large government purchases.
Japan has some of the world’s biggest pension funds, led by the Government Pension Investment Fund (GPIF). GPIF alone has more than $1trn of assets. Encouraged by Abe and the low yields on Japanese government bonds, these institutions are planning to meaningfully shift asset allocation away from bonds and towards stocks, with much of the focus on domestic equities.
While GPIF has already moved part of its allocation over to equities, other domestic pension funds have yet to follow suit. These purchases come in addition to those carried out by the Bank of Japan as part of its quantitative easing programme. GPIF and the Bank of Japan will both concentrate a portion of their purchases on the JPX-Nikkei 400.
These asset purchases are huge in their own right, and represent a big part of the story of why Japanese equities should do well.
Our preferred measure for comparing Japanese earnings to the rest of the world is price-to-cash earnings. Unlike price-to-book, this figure is less biased by the deflation of book values. And unlike price-to-earnings, this figure makes some adjustment for different accounting practices. On this measure, Japan is trading at a 29% discount to the US, a very large disparity in both relative and historical terms. Only six years ago, in 2009, they were at parity.
What about the lack of wage growth?
We often hear this question as wage growth is something on which Mr Abe has pinned his hopes. We take a relatively benign view of the modest wage growth taking place.
Wage growth is now positive, ending years of wage deflation. This should be enough to help Japan break its cycle of debt deflation, which is crucial for the sustainability of their public debt. Indeed, it is already working – witness the sharp improvement in government finances. Yet current wage growth is not so high as to erode corporate profit margins meaningfully. While Mr Abe is right to worry that only modest wage growth might not make good politics, it does not harm shareholders.
We believe that the market has only begun to appreciate the changes coming to corporate Japan, and we are well positioned to capture the future upside in the multi asset strategies that we run.
Christopher Mahon is investment manager and director of Asset Allocation Research at Baring Asset Management