Japan stages a comeback on governance reforms
After years of attempts at policy stimulus and structural reform, Japan’s economy is on track to perform better than we expected this year — albeit far from an upside breakout given the onerous demographics.
New incentives for better governance have encouraged companies to focus on shareholder returns, and the tone of our conversations with company management teams has improved dramatically over the past couple of years.
In our view, Japan has strong earnings fundamentals and attractive valuations relative to other major developed markets, along with compelling investment themes and favorable currency trends.
State Street Global Advisors’ fundamental growth and value and asset allocation teams view Japan as a particularly interesting opportunity, with overweights across a number of strategies as a way to play the global growth recovery.
Little Moves in the Right Direction
After Shinzo Abe was elected prime minister in 2013, Japan embarked on a bold policy experiment characterized by the three arrows of fiscal stimulus, monetary accommodation and structural reform. Based on measures of the Japanese economy, however, we could argue that the impact of “Abenomics” has been limited: Real GDP growth has hovered around 1% for the past two years, and we have only modestly raised our expectation for 2017 to 1.25% on some upside economic surprises in the short term.1 Core consumer price inflation excluding volatile food and energy has stayed stubbornly below the 2% targeted by the Bank of Japan (BOJ). And wage inflation has been largely absent, although unemployment stands at 2.8% — that is, roughly 1.5 jobs available for every applicant.2
Even so, the BOJ and the Ministry of Finance (MOF) are committed to reflating the economy. As ever increasing asset purchases have become infeasible, the central bank has pledged not to hike rates while establishing a policy of yield curve control (YCC) to limit the damage that a negative slope can do to bank earnings.
We believe Japan is one of the most politically stable countries in the world now. With a solid political base, Abe is likely to call an election in the lower house of the National Diet by early 2018, which raises the likelihood of more fiscal stimulus that could be good for the investment environment.
New Culture for Corporate Governance and Stewardship
Less has been done on the third arrow of structural reform. In a country where the fastest-growing age group is over 80 years — an ominous demographic headwind, indeed — tight immigration policies and women’s lesser status at work leave a lot to be desired. Yet we have perceived major inroads as the government has put incentives in place to promote a culture of better corporate governance and stewardship.
We used to find capital inefficiencies across Japanese business sectors, with shareholders having little input on allocation decisions. Now we can meet with management teams who are open to discussing topics like excessive cash balances or crossholdings that would have stopped the conversation in the past. Capital allocation policies have changed, with firms increasing dividends, repurchasing shares and seeking to improve balance sheets and returns on equity (ROE). Japan’s Financial Services Agency (FSA) has focused on transforming corporate behavior, revising the stewardship code so that companies report how their investors voted. In what has traditionally been a shame culture, this is a way to bring to light those firms that are not doing the right things. And we have seen some success among activist shareholders, which had been unthinkable before.
Perhaps most encouraging, a new tax-efficient way of issuing restricted shares to employees will allow more Japanese companies to offer stock incentives — not only boosting domestic demand, but also serving to align company interests with those of stakeholders. In our view, the economic environment has an impact, of course, but the TOPIX equity benchmark tends to move with ROE. So the real cornerstone of the investment case for Japan is whether management teams will continue to make the right decisions. Based on our observations of an expanding market ROE, that evolution has proceeded favorably.
Earnings Growth Higher, Valuation Multiples Lower
Following several years of robust gains, Japanese company earnings were up another 28% in the first quarter, with more surprises than in any other developed market (see chart below).
Using a conservative forecast of the yen (JPY), we believe the earnings can expand at a pace of 9%-10%, with the potential for faster growth next year given the positive signposts in the marketplace. Our bottom-up stock pickers are finding many opportunities that screen positively on qualitative and quantitative factors, including sustainable growth rates and improving estimate revision cycles.
In the past, the Japanese equity market could be considered attractive only compared to its own history, never other markets. After peaking at a remarkable six or seven times book value in the mid-1980s, Japan is no longer a special case, and price to book (P/B) and price to earnings (P/E) are now on a par with developed country peers. Japan’s dividend yield has increased impressively, almost equal to the US, and could go even higher as more companies raise payouts.
State Street Global Advisors’ fundamental growth and value teams view Japan as particularly interesting at the moment, with overweight allocations across a number of strategies.
Overall, we find a compelling argument for building our position in Japanese equities by increasing our existing tactical overweight to the region as a play on the global growth recovery, with the currency probably working in our favor — particularly against the USD — and without the crowding starting to be seen in flows to Europe.
To learn how markets around the world are likely to fare for the rest of the year, check out our mid-year market outlook at www.ssga.com.
1 Japan Press, “Coincident Index Hits 9-Year High on Robust Auto Production, Consumption,” June 7, 2017.
2 Wall Street Journal, “Global Jobless Rates Are Low, but Paychecks Aren’t Getting Fatter” by Yoko Kubota, June 6, 2017.
Return on equity (ROE). The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
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