This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
Whilst the Japanese economy continues to grow at a rate well above its long-term average, my investment approach is still anchored around the belief that a rigorous, bottom-up approach to active management can consistently identify companies where the market is underestimating or mis-pricing future growth potential.
The Bank of Japan continued to support equity markets through the purchase of exchange traded funds, maintaining its annual target of around ¥6 trillion, or £40 billion. Trading activity by overseas investors was relatively volatile over the past year, with the bulk of the net buying coming after the decision to hold a snap election was announced in mid-September.
Labour markets are now at the tightest level in several decades and participation rates among women and also seniors over 65 have risen sharply. The number of people in employment is now close to the record high of 65.8 million set in 1997, which is helping to mitigate the impact of changing demographics.
Meanwhile, foreign visitors are coming to Japan in record numbers; 28.7 million in 2017 versus 8.4 million in 2012 prior to the advent of Abenomics, and are on course to reach the government’s target of 40 million by 2020, the year of the Tokyo Olympics. All of these factors have positive implications for the domestic economy, through higher total employment income, stronger consumer confidence and ultimately consumption.
What About Stocks?
In terms of corporate fundamentals and valuations, Japanese stocks are relatively cheap globally and the earnings environment is positive, suggesting a reasonable level of upside for the market in 2018.
Although Japanese stocks have performed strongly in recent years, the market has been driven predominantly by growth in corporate earnings rather than by an expansion in valuation multiples, as has been the case in other developed markets such as the US. As corporate Japan continues to make progress with governance reforms and enhancing shareholder returns, returns on equity could approach similar levels to those seen in Europe.
The key risks are policy missteps by major central banks; the re-emergence of trade protectionism, particularly in the US; a faster than expected slowdown in China; and geopolitical tensions. While core-core inflation remains subdued in Japan, speculation that the Bank of Japan may change its policy could lead to periods of yen appreciation, which would negatively impact the performance of Japanese stocks.
However, the Japanese economy is experiencing its longest period of growth in more than a decade and the policy mix remains accommodative. Corporate profits are at record highs and companies are increasing their capital spending. Given this environment and the relatively undemanding valuations in Japan, we believe there are attractive investment opportunities in the equity market.
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