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Japan: On Target

While many column inches in the financial press have been devoted to global-trade rhetoric and changes to interest rates and the release of new money by central banks in developed markets, some topics that were previously much discussed have been almost unheeded. One such subject is Japan’s stock market. Any coverage relating to Japan has focused on a perceived slowdown in economic growth and the actions of the Bank of Japan (BoJ).

The received wisdom pertaining to investing in Japan is discouraging: it has a problem with deflation (falling prices); a pile of public debt; and historically, its corporations have paid little attention to the notion of rewarding shareholders. And yet these long-standing concerns have been subject to significant change. Political, monetary and systemic reforms have created a more supportive background for Japanese companies, making them attractive investment propositions.

Company profits are rising sharply, outperforming even those of US businesses. Yet the share prices of Japanese companies have so far failed to keep pace with those of US stocks. This had left them comparatively cheap and potentially better value for some investors.

To understand why this is the case, we need to look at ‘Abenomics’. This is the phrase used to describe Prime Minister Shinzo Abe’s three-pronged approach to financial rescue, and the effects that the plan’s ‘three arrows’ have had on the corporate world in Japan.

Abe’s first two arrows

Mr Abe’s target for the first arrow is an inflation rate of 2% in Japan, brought about by massive monetary stimulus. So far, the BoJ has poured around ¥537 trillion (around $4.9 trillion) into the country’s economy, with the aim of generating a steady increase in consumer prices. The theory is that with more money chasing the same amount of goods, prices will be driven up.

As mentioned above, prices in Japan have historically either risen very slowly or fallen. This can lead to a stagnant economy as individuals and companies see little reason to spend or invest their money when goods are cheap or are likely to become cheaper. Instead, they tend to save.

As yet, it has not quite been successful. In its July 31 Outlook Report the BoJ admitted that it will take “more time than expected” to achieve this target.

The second arrow is intended to increase Japan’s economic growth through reduced tax rates or by increasing government spending. This in turn will attract more tax revenue and ultimately reduce public debt. The country’s government has been splashing the cash in a variety of areas from welfare to infrastructure (particularly those related to the upcoming Tokyo Olympics).

Turbulence along this arrow’s flight path came in the form of a controversial increase to the country’s sales tax. The levy was intended to help the country rein in its large debt burden. However, the hike ended up pushing Japan’s economy back into recession in 2014 - albeit briefly – as it discouraged individuals from spending. And according to official reports, Japan’s economy shrank at an annualised rate of 0.6% over the first quarter of 2018.

But these figures do not give the whole picture. Instead of looking solely at economic growth as measured by nominal gross domestic product (GDP), investors should pay close attention to Japan’s ‘real’ GDP per person (see “Explained” for a summary of the difference between the two). This measure has been increasing more quickly in Japan than in all other industrialised economies1, boding well for Japanese incomes. This is also good news for share prices of Japanese companies as individuals will have more to spend on their goods and services.

The third arrow

“Part of its strength is its breadth: it is less a single arrow than a 1,000-strong bundle of acupuncture needles.” So said The Economist in an article published on 26 June 2014 when describing Abe’s third arrow, that of systemic change. It has many objectives, from shifting Japan’s labour-market demographics, to altering agricultural policies. But it is widely viewed as being the arrow still furthest from its target.

One of the most interesting “needles” for investors is the one bearing the label ‘corporate governance reform’. Several new pieces of legislation and guidance have been designed to provide more clarity for shareholders, and to encourage corporations to reduce their cross-shareholdings: a system whereby a group of companies hold shares in each other’s businesses to help insulate each company from stock market fluctuations and takeover attempts. This system of intertwined shareholdings, known in Japan as a keiretsu, helped to bolster Japan’s economic recovery in the aftermath of the Second World War, and has allowed companies to implement long-term plans, but has acted as an obstruction to the rights of external shareholders in more recent times.

Another initiative is the introduction of the JPX-Nikkei 400 Index, which includes only those companies that are focused on rewarding shareholders. It has encouraged more companies to concentrate on paying dividends, and reinvigorating interest in owning shares in Japanese companies.

Bullseye?

Of course, it is important to weigh up the risks of holding Japanese stocks in relation to the potential rewards, but as a developed market with sound growth potential, in our view the balance should be relatively favourable. Overall, an environment of strong corporate profits, and an increased likelihood of dividends being paid to shareholders are very encouraging. It’s debatable whether any of Abe’s arrows have yet struck completely true, but their effects have certainly left Japanese stocks looking appealing to some investors.

1. Sources: Oxford Economics, OECD, Lloyds Bank plc, June 2018.

 

Important Information

Forecasts of future performance are not a reliable guide to actual results in the future, neither is past performance a reliable guide to future performance. The value of investments, and the income from them, may fall as well as rise and cannot be guaranteed. Any views expressed are our in-house views at August 2018. Investment markets and conditions can change rapidly and the views expressed should not be taken as statements of fact nor relied upon when making investment decisions. This information may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

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