Key points
- Signs of life are emerging in Japan after a long period out of favour, with issues such as deflation and cross shareholdings increasingly consigned to history.
- Japanese equities are among our favoured markets on the Liontrust Multi-Asset team, with the country’s old economy cyclical and value companies well placed to benefit from global recovery.
- Vaccine coverage is a growing concern, however, with the country only just starting its inoculation drive. Public appetite for the Olympics, due to start in July, is diminishing.
- We invest in Japan via a blend of underlying funds: while value managers currently see potential for a sustained rotation, there are also ample growth opportunities in areas such as digital working.
Japan has dropped off many investment radars over recent years, with critics falling back on traditional claims about deflation and cross shareholdings, but there are indications this long-term aversion is starting to turn.
Signs of life have emerged this year as the Nikkei breached 30,000 for the first time in three decades in February, and Japan was among the world’s most resilient economies in 2020, with its 4.8% contraction less than half the 9.9% in the UK. Japanese equities are currently rated a four on our target tactical asset allocation (with one the most bearish and five the most bullish), and we see several attractions for what remains a cheap market – albeit with potential Covid-19 and vaccine red flags to keep in mind.
Japan has a large proportion of old economy cyclical and value businesses and its broad exposure to industrials and exporters means the country is well placed amid an ongoing global rebound and reflation. US bond yields are starting to rise after a long period of decline and the general perception is that this tends to benefit old-economy names and penalise growth, or long duration, stocks. Areas like technology are thought to be under greater threat as they rely on future earnings and are therefore more vulnerable to an increase in the bond yield used to discount those earnings.
Taking a broader view, the corporate regime change ushered in by former prime minister Shinzo Abe’s Abenomics programme has been effective in pulling Japan out of its long slump, particularly the third structural reform ‘arrow’. Abe was forced to step down last year due to ill health but his successor Yoshihide Suga is keeping the fundamentals of Abenomics intact and bringing greater focus to the country’s growth strategy backed by a digital revolution – although it should be noted he has an election to fight by October and his popularity is waning as Covid cases rise.
On that digital theme, transforming the current low penetration rate in areas like e-commerce is a potential growth driver and, without resorting to clichés, this slow adoption is likely to be down to demographics, with Japan’s population by far the oldest in the world. As the following chart shows, almost a third (more than 35 million people) are aged over 65 and there are 2.3 million in their 90s and over 70,000 centenarians. To bring things full circle, this situation was one of the primary motivating factors behind Abenomics in the first place, with the policies ultimately designed to boost the low GDP and diminishing productivity rate inherent with an ageing population.
Overall, Japan has seen a recent pick-up in earnings and analyst upgrades ahead of the US – as would be expected considering the make-up of those respective markets – putting it alongside Europe (including the UK) as a good reflation play. Corporate debt is also fairly low and companies, on the whole, are managed sensibly and conservatively; the long-term criticism has been that they are also run without much diversity, transparency or for the benefit of external shareholders, but again, there are signs this is beginning to change.
Cross shareholdings have traditionally been seen as the worst example of poor transparency, where Japanese companies invest in each other and protect underperforming management teams via a cushion of automatic shareholder support. Although this practice has been declining since the 1990s, around 11% of Japan’s listed companies still have a listed shareholder owning more than 30%, compared with just 0.9% in the US and 0.2% in the UK. Critics suggest this has fostered complacency, low returns on equity and poor governance, but developments such as 2015’s corporate governance code and new rules on the Tokyo Stock Exchange (TSE) suggest it could be edging closer to extinction. In April next year, the TSE will move its more than 3,700 stocks to a three-tier system – prime, standard and growth – with membership of the prime index depending on the annual end of March level of free-floating market capitalisation, excluding cross-held shares.
To deal with the other traditional ‘mired in deflation’ criticism of Japan, the so-called lost decade of the 1990s actually lasted for most of the subsequent 20 years but the situation had changed to such an extent that Bank of Japan (BoJ) Governor Haruhiko Kuroda declared ‘victory’ in July 2019, claiming that for the first time in about 15 years Japan's economy was no longer in deflation. Covid-19 has obviously turned things on their head once again, however, and hit spending on services, which make up around a third of total consumption in Japan. While deflation is not expected to return, Kuroda has acknowledged the need for vigilance on price moves – putting the BoJ among the many central banks basically collaborating with governments to chart a course through Covid. It recently introduced a lending promotion interest rate system, for example, to encourage banks to lend by giving them new incentives, with these increasing if rates go further into negative territory.
While the Bank maintained its growth predictions at around 4% for the current fiscal year at the April meeting, despite Covid concerns, it was forced to revise down inflation forecasts again, putting the long-held 2% goal further out of reach. The BoJ has consistently fallen short of hitting the target it considers key to turbo-charging the economy, despite a series of stimulus and monetary easing packages. New forecasts are for just 0.1% inflation for the fiscal year ending March 2022, down from a previous outlook of 0.5%, and, in contrast to many other countries where concerns are increasing about rising prices, Japanese inflation is not expected to breach 1% until the year ending March 2024.
Despite many improving fundamentals, at least at company level, recent weeks have seen growing fears that Japan’s progress could be derailed as the country tries to contain its latest wave of Coronavirus. At the start of the year, Suga declared a state of emergency in several prefectures due to climbing cases and he reintroduced this in Tokyo, Osaka and two other areas at the end of April in another attempt to halt the surge. These latest measures cover around a quarter of Japan’s population and a third of its economy, and are in place until at least the end of May.
In many ways, Japan is a victim of its initial success in handling the pandemic, although opinion varies on whether this was down to luck or judgement. Rather than the harsh lockdowns imposed around the world, the country started off with messaging about avoiding three Cs: closed spaces, crowded places, and close-contact settings. Japan’s death rates were initially by far the lowest in the developed world, with many attributing much of this to an existing culture of mask-wearing.
As the situation has worsened, however, relatively low levels of infection early on has meant there is little immunity and Japan is also far behind in terms of vaccinations: compared to more than half of adults in the UK and US having had at least one jab, Japan is at a miniscule 2-3%, only just thinking about inoculating its large elderly population. A range of reasons lie behind this, from shipment delays to strict approval standards, but the bare fact is that of the main vaccine options, the country is only offering Pfizer at present, with Moderna expected to be endorsed imminently and AstraZeneca still under debate. Despite this, Suga has pledged to have enough doses for the country’s 126 million people by June. Japan was previously a world-leading developer of vaccines but this ground to a halt in the early 1990s, with a court decision that ordered the government to pay compensation related to any side effects of inoculations.
Again, it is difficult to know what impact this might have but it seems sensible to suggest that while Japan remains highly geared to a global rebound, its own domestic recovery could be impacted. Fourth-quarter GDP figures were well ahead of expectations, sparked by ‘revenge consumption’ as people made up for lost time, but the worsening Covid situation led to the country’s first GDP decline in three quarters in Q1 and given recent events, a fall in Q2 seems likely; according to the formal definition, this would put Japan back in recession. All this is also happening just a few weeks before the proposed 23 July start of the delayed Tokyo Olympics and it remains to be seen whether the country can get this event away. Public appetite is falling, with a recent poll finding nearly 60% of the population want them to be cancelled. Current thinking suggests the Games will be held without spectators but even if they are abandoned, this would not come as a surprise and the impact on the economy and market should be limited.
When selecting funds in any region, our preference is to blend growth, value and core/index offerings and our current positions in Japan are particularly strong representatives of their respective styles. Man GLG Japan CoreAlpha is on the value side and manager Jeff Atherton – a long-term team member who recently took the lead manager role from the retiring Stephen Harker – claims a combination of a less crowded market (with value’s outperformance in Q1 coming after eight consecutive quarters of growth ascendancy), cyclical resurgence, valuation stretch, and market inefficiency is currently making Japan an attractive equity destination for value and means the rotation looks here to stay.
Atherton also highlights a quirk of the country’s corporate governance regulation, which he calls the paradox of the 8% return-on-equity (ROE) target. Since 2016, corporates have been directed to aim for an 8% ROE, with shareholders encouraged to vote against boards that fail to reach this target three years in a row. For stockpickers like Man GLG, this represents a huge, highly predictable market anomaly without high levels of foreign inflows that would compete it away. Most importantly, the likelihood of a cyclical uplift means several stocks with high levels of operational leverage are likely to be able to raise their ROE above 8%, presenting opportunities for active managers; businesses that achieve the 8% are rewarded via a price-to-book premium while those that fail to do so have their multiple crushed.
Atherton acknowledges doubters will point out these value arguments have been made before and a resurgence for growth stocks may come over the rest of the year. However, if GDP is rebounding, in Japan and globally, after last year’s economic shock, he asks why investors would pay up for highly valued growth stocks if ‘growth’ is spreading more liberally throughout the economy.
Highlighting the scope of companies available in Japan, however, our growth option in the region, Baillie Gifford Japanese, continues to focus on opportunities in areas such as the country’s new approach to digital working, which is giving entrepreneurial companies more of an edge. Despite technological superiority in fields such as robotics, automation and precision engineering, Japan also retains an archaic affinity for paper transactions. One holding in the Baillie Gifford fund is Bengo4.com (pronounced bengoshi, Japanese for lawyer), an online legal platform whose CloudSign service enables contracts to be digitally signed and stored. The shift to home working at the start of the pandemic highlighted a particularly Japanese anachronism, the hanko seal, a personalised name-stamp to sign and certify documents. The government has set up a task force to oversee the implementation of digital contracts to replace these and this is proving a tailwind for such companies, whose products save time, reduce costs and make regulatory compliance easier.
According to Baillie Gifford, IT can enable greater business agility in Japan; when done right, it breeds flexibility and sharpens the flow of information, a profit driver rather than a cost centre.
With Japan’s stock market back at levels last seen in 1990 and long-term spectres of deflation and cross shareholdings moving towards the past tense, we continue to see reasons to be positive about a cheap market benefiting from global recovery. As events in India have shown, however, no one can afford to be complacent on the pandemic and we are keen to see that vaccination percentage moving upwards in short order; pledges for one million doses administered a day from 24 May are a first step towards that.
