Monetary policy
In January, the Bank of Japan set a 2 per cent inflation target in addition to an open-ended asset purchase programme and in April unveiled a plan to double the monetary base within two years via increased buying of government bonds.
Given that Japan has experienced deflation for a generation, we think this is an ambitious target that is not absolutely necessary. The key change will be moving Japan from a psyche of falling asset prices to an expectation of appreciating ones. Achieving this will have a significant, positive impact on consumption and investment trends.
Fiscal policy
The second arrow involves a fiscal boost from increased public spending, which remains constrained by the state of Japan’s public finances.
The country has a debt-to-GDP ratio in excess of 200 per cent after more than two decades of sluggish growth, near-zero interest rates and repeated attempts to prime the economy.
Market reform
The third arrow involves sweeping structural reforms aimed at invigorating the supply side of Japan’s economy by, for example, making it easier to restructure the labour force and breaking down historical restrictive practices.
Abe has talked about ending some protections enjoyed by Japan’s farmers, widening free trade agreements across the Pacific, improving education, cutting regulations and opening up domestic utilities to greater competition.
A rise in inflationary expectations should cause demand to increase, which should lift production and in turn boost corporate earnings.
How is the new policy faring?
Most of the initial firepower has come from changes to monetary policy and the early success has been significant. The yen has weakened against the dollar by about 12 per cent year-to-date, making Japanese goods more competitive.
The TOPIX has gained around 29 per cent in yen terms year-to-date compared with a near 20 per cent fall over the previous five years.
Given Japan’s fairly consensual, egalitarian society, increased profits will likely be passed on in the form of higher wages, which should mean increased household income and spending, which in turn reinforces this virtuous circle.
The early signs are encouraging, including an improvement in credit indicators and upward earnings revisions.
However, although the yen has weakened significantly over the past 12 months, it is still trading above its level of seven years ago. Also, a further weakening of the yen is not necessary for the positive Japan story to continue.
The key to Japan’s success will be innovation and improvements in productivity. If corporate Japan’s improved profits can be ploughed back into research and development, then perhaps we can see a sustained improvement in market share.
Japan is still the world’s third-largest economy and with the eurozone still mired in sovereign debt issues and China on a lower-growth trajectory, a stronger Japan is good for the global economy.
There has been less clarity and more market scrutiny on Abe’s growth and reform policies. In July there are Upper House elections that Abe needs to win to take on vested interests.
Abe’s progress will be watched by markets over the summer, particularly on the Trans-Pacific Partnership (TPP) talks, a US-led effort to liberalise trade across the Pacific region.
What has been the effect on equity valuations?
Japan’s earnings-per-share (EPS) growth is currently leading the world. Moreover, the average price/earnings ratio for Japan equity is now cheaper than for US equity, in marked contrast with the past decade.
Price/book measures are cheaper than those found in many other markets and dividend yield is the same as in the US. This means Japanese equity valuations are now on a commensurate basis with stock markets around the world.
Historically, it has been tough for Japanese companies to secure loans for working capital. The corporate culture has also been characterised by a concern for stability over short-term bursts in profitability, which is why Japan has typically had lower return-on-equity (ROE) ratios than other major markets.
While we don’t expect this to change dramatically any time soon, margins could improve on the stronger yen and better growth prospects, which will likely lift ROE measures.
We think that the oft-cited headwinds for Japan of corporate governance, demographics and competitiveness have all been excuses not to invest in the country while the market was de-rating. Now this is complete, we believe it’s time to look at these factors afresh.
What sectors do we expect to benefit and do demographics matter?
Japan is a classic anti-ETF market, where active equity research is a more attractive solution than a passive one. It is important to identify the companies that will really benefit from structural reforms.
This is why a bottom-up approach is so important, in search of firms that can produce disruptive technology and secure new markets for themselves. To succeed, Japanese manufacturers must innovate and start making things that people want to buy again and become more commercial and aggressive.
This is why reform is so crucial. Everyone is aware of its ageing society and the headwinds this poses, but if you can achieve productivity increases via reforms, then you don’t need to increase the population.
By extension, there is no direct correlation between gross domestic product (GDP) growth and stock market returns in the short-term.
Demographics can play to your advantage in Japan as an investor, and currently we like manufacturers of medical devices, nursing home providers and some private kindergarten providers.
Investors should also keep an eye on domestic reflation plays as discretionary consumption improves on rising asset prices. Rising asset prices and loan growth should be positive for real estate and financial sector stocks, including banks.
More importantly, as Japan gradually recovers its vitality, we are focused on identifying the winners of tomorrow, and we favour some particularly innovative auto companies.
What is driving recent stock market volatility?
By early June, Japan’s stock market had dropped more than 12 per cent from its May highs and the yen had begun to tick higher again, prompting worries it had re-entered bear market territory. Investors are also keeping an eye on the Bank of Japan’s efforts to stimulate inflation without recklessly driving up interest rates on government debt.
However, the market has since recovered some poise and the TOPIX still remains one of the best performers in the world this year.
Most observers see the recent turbulence as a correction and not a reversal of the strong upward trend, although there is lingering scepticism from some quarters that Abe will be able to implement his reforms in the face of vested interests, such as Japan’s farming lobby.
Abe recently promised to relax rules governing the sale of non-prescription drugs and allow selected cities to experiment with lower taxes and deregulation.
Later this month he is expected to approve reforms aimed at making labour markets more flexible, bringing some nuclear plants back online and drawing more women into the workforce.
With regard to current fund flows, there has been increased interest from foreign investors but no flood as yet. Domestic investors have returned to mutual funds and directly to stock investing. There has also been some selling into strength as pension funds and institutional investors seek to maintain their Japan weightings at approved levels.
Ultimately, we expect more buying as allocations increase and Japan’s stock market continues to respond to Abe’s policies.
Conclusion
Abe’s policies have changed short-term sentiment and inflationary expectations are brewing. Near-term, corporate fundamentals are also supportive and valuations are no longer expensive. Although the Bank of Japan’s 2 per cent inflation target is ambitious, the more potent achievement in Japan would be a change in the country’s psyche from expectations of falling asset prices to rising ones.
Abe’s progress on structural reform will be the key to the long-term success of his policy experiment – only that can unlock the productive potential of Japan’s economy and drive future growth. Abe’s ability to get Japan into the TPP is vital and he recently indicated that he has managed to secure some exemptions for domestic agricultural products.
We believe the 2011 earthquake and tsunami was a defining moment for the Japanese people. Not only did they need to work together to overcome this human tragedy, but after years of economic gloom, many have now decided enough is enough and the status quo is no longer acceptable.
This renewed vigour has found a voice with Abenomics and we expect to see a more assertive Japan in the months and years ahead.
Alex Treves is head of Japanese equities at Fidelity. The views expressed here are his own.
