After two decades of disappointment Japanese equities posted an incredible 57 per cent return in 2013. Leading institutional investors met in Melbourne to discuss if there is more growth to come.
Investing in Japanese equities comes with the baggage of around 20 years of underperformance relative to other developed nations. The causes have been a) deflation b) worries over government debt c) an ageing population
d) Chinese growth overshadowing Japan in Asia e) Japanese corporates not favouring the interests of investors. Anyone sensing a turnaround has often been burnt.
Fraser Murray, senior consultant at Frontier Advisors, has seen no shortage of such attitudes. “In the last 20 years there have been a number of fund managers who have decided that now is the time to venture into Japanese equities,” he says. “And almost without exception, they have regretted it. To some extent it has scarred them.”
For this reason most were not positioned for the big surge in 2013, when the Japanese equity market grew by 57 per cent.
“It got away from fund managers very, very quickly,” he says. Indeed, according to Murray the vast majority of global equity managers are underweight Japanese equities compared to the approximate 10 per cent weighting in the global benchmark. There are a few exceptions, says Murray. “Some of the more growth-oriented or momentum-oriented managers have just started to tick up to 112, 113, 114%.”
The turnaround in the Nikkei index has been due to Shinzo Abe, the Japanese prime minister, who on election to his second term in December 2012 created the three arrows policy to end two decades of gentle decline in the economy. These measures were; a monetary stimulus to boost the economy and lower value the yen, thereby raising exports; secondly, fiscal encouragement to spend; and thirdly, structural reform policies to encourage growth, the latter of which more is expected. The impact has largely been successful.
For Miyuki Kashima, head of Japanese equities at BNY Mellon Asset Management Japan, this is the first time in a long while that she has felt extremely positive – foreseeing not a couple years of growth, but potentially 10 years.
One of her reasons for optimism is the basic demand and supply of Japanese equities, with so many investors underweight, it will only take a small shift back to neutral to raise valuations. “If we see another 2 per cent or 3 per cent nominal growth for several years, as we get confirmation that we are no longer in a phase of contraction, then people will become less sceptical and that is when the underweight position is going to gradually go towards neutral,” she says.
Kashima points out that even after the big rise in 2013 the Japanese stock market is still significantly behind the curve. The MSCI world index has recovered to 2006/7 levels and beyond, but Japan has not, partly because of the impact of the economic damage caused by the 2011 earthquake and tsunami off the Pacific coast of Japan. She believes the current levels of earnings per share should lead to an extra 40-50 per cent rise in valuations to reflect fair value.
“In the new financial year the consensus is for 10 per cent EPS growth. Extremely bullish brokers, such as Goldman, are looking for a 25 per cent increase,” she says.
Answers to scepticism
A key objection to investing in Japan is government debt at 240 per cent of gross domestic product. For Ian Lundy, chief investment officer of the Retirement Benefits Fund, the threat of default looms large. “When debt gets this high – even at current interest rates – 24 per cent of government revenue is going to pay interest,” he says. “So you are almost at the point of no return where, once debt gets so big, there is no way out other than default.”
Kashima thinks a mixture of inflation and rising revenue will help alleviate this debt and that much of the revenue will come from the public’s savings, particularly in the form of higher inheritance tax and from sales tax.
The pretext of inflation though was challenged by Andrew Alyward, research director at Pitcher Partners, who thought wage rises in particular would be dampened by temporary or contract workers. “I do not see that, that kicker is going to be as large when you have such a large percentage of non-permanents and you also have a lot of corporations off-shoring now, so there is even less work,” he says. “You also have a labour force that is shrinking, by 600,000 odd people a year.”
This fear was echoed by Chris Schodde, senior investment analyst at Kinetic Super. “It is quite difficult to see the growth and the inflation being, at this stage, quite certain and sustainable. There is still a lot of risk on the table and the pricing is not necessarily the most attractive after a 50 per cent run up.”
Aylward also wonders how much of that pick-up in sales is sustainable ahead of the forthcoming sales tax.
Kashima agrees some hold this view but points to other indicators, such as a bottoming in office rents.
Lundy is also cautious on whether the growth in spending has long term momentum, not least because the sales tax might take too much out of the economy and whether a fall in the value of the yen will squeeze the margins of domestic companies and consumers by pushing up energy and food costs.
For Kashima, there is an expectation that companies will be able to increase prices after years of deflation. “Before, Japanese companies used to say, ‘We could not possibly pass it on to consumers’ – partly because when you are in a deflation environment, you cannot pass it on – but now, with the whole mind-set changing, everything is going up anyway.”
She does not think wage rises will squeeze margins, as companies would not do that if their own margins were cut, and points towards a rise in inheritance tax last year and a tax change that allows grandparents to set up a trust account and transfer up to about $200,000 if it is used for education. “As you know, a lot of the wealth rests with the elderly,” she says. “From the time the inheritance tax was announced, it was almost like the older people suddenly realized, ‘I can’t take this money with me. I am going to spend it.’”
One common concern of overseas investors has been a corporate unwillingness to accept shareholder engagement or to pass on large cash reserves as dividends to investors.
Andrew Phillips, institutional business director, BNY Mellon Investment Management, answered objections to this cultural divide which is limiting weightings to Japanese companies. “Western global equity investors just do not see cash accruing on balance sheets as a productive way of dealing with cash. To the extent that more of those Western ways get in to the management of Japanese companies, I think we could really see a change in that mentality and the approach to what that Japanese equity weight is.”
Kashima thinks change will happen slowly, possibly through government intervention. “The Japanese are beginning to think about shareholders and paying out dividends. It is much higher on their agenda than it was 20 years ago or ten years ago; and also, with deflation ending, they are going to start spending some of that money.”
One other worry for investors is the often strained relationship between China and Japan. Schodde was worried about Chinese resentment over Japan’s occupation of large parts of their country 1931-1945 and sensitivities to events such as massacres that took place in Nanking. “It does not help when you have Abe visiting the Yasukuni Shrine, which venerate some of these war criminals who participated or sanctioned these events. And then, you also have the Senkaku Islands dispute,” he says.
Kashima thinks trade will prevail. “With China the hard feelings are still there, but it is one of the biggest trading partners, and we would not have got there if that was such a big issue.”
Five positive indicators for Japan
Lending should rise
The loan to deposit ratio of Japanese banks fell from approximately 100 per cent 20 years ago to 60 per cent now. Kashima believes it will rise back to 100, a figure similar to the US and Europe, due to the impact of inflation encouraging spending. “I know some people say, ‘Well, the Japanese like saving, so maybe they do not have more’. That is not the case. We were at 100 back in the early nineties.”
Political will for change
The ruling Liberal Democrat Party in Japan enjoys a two-thirds majority in the lower house, a majority in the upper house of government, while Shinzo Abe the prime minister since 2012, has a 56-57 per cent support rate. Kashima sees this as an unassailable mandate for change and she is struck by how bold Abe has become in pursuit of his economic policies after years of weaker prime ministers, who favoured consensus and minor changes. “We have this prime minister now who is very bold and effective, and the nation seems to be ready for quite considerable change after its 20 years of stagnation,” she says. “He is the first prime minister to say, ‘Deflation is bad – we have to put an end to this’.” Under Abe she notes the Japanese appear willing to accept change they resisted in the past; such as the rise in inheritance tax.
Inflation replaces deflation
The governor of the Bank of Japan, Haruhiko Kuroda has set a target of two per cent inflation to help encourage spending and growth, after years of deflation. Kashima explains the damage brought. “If you are in a deflationary environment, anything you want to buy today – if you are thinking of investing – is cheaper next year, and the year after.” The advent of inflation is encouraging people and companies to spend before prices rise. That is going to start changing people’s minds about investment, spending and borrowing, because the Japanese are like anyone else: if you think it is cheaper to buy today and if there are opportunities to grow one’s business by borrowing money, they will do it.”
Positive outlook for domestic companies
Japanese companies such as Honda and Sony are familiar to most but such prominent exporters only represent 15 per cent of the stock market. Following Abe’s stimulus measures it was domestic companies, such as those in cement and real estate which did best in 2013. “Part of the reason why the Japanese market has, basically, not done very much is that the only interesting bit was exporters,” says Kashima. “Exports are 15 per cent of GDP, which sometimes surprises people. We have got a huge domestic economy, as well. If that bit starts to turn around, then you do not have just the 15 per cent of the economy pulling up, or trying desperately to do better to support the economy. You have the 85 per cent now turning around.”
It is well known that the low birth rate in Japan is leading towards a decline in the population, which worries many investors. One estimate puts the working-age population declining from 82 million in 2010 to 68 million in 2030. Shinzo Abe is trying to find a short-term solution to the problem by encouraging more women in the work force. Kashima says: “The Prime Minister has said, ‘I want more women to participate in the workforce’. No other prime minister in the past has said that. He has actually gone out there to companies saying, ‘If you have competent women I would really like to see at least one on the board.” Japan has a very low female participation in the workforce compared to other countries. A recent global Gender Gap Survey showed Japan ranked 105 out of 130 in terms of its openness to women. Currently around 80 per cent of women do not go back to work after having children, much of this is due to a lack of day care facilities, something Abe is changing by providing new 200,000 day care slots. Kashima thought immigration would also be opened up in certain industries.
Miyuki Kashima, managing director, BNY Mellon Asset Management Japan
Chris Schodde, investment analyst, Kinetic Super
Fraser Murray, senior consultant, Frontier Advisors
Andrew Aylward, research director, Pitcher Partners
Ian Lundy, chief investment officer, Retirement Benefits Fund
Andrew Phillips, institutional business director, BNY Mellon Investment Management
David Rowley, editor, Investment Magazine