It is six years this month since Shinzo Abe became Prime Minister in Japan, making him the longest serving Japanese Prime Minister ever. Since being elected, Abe has implemented significant economic reform, including an unprecedented monetary easing programme.
This has buoyed markets – the Japanese stock market is up more than 100% over Abe’s tenure – but many believe valuations still don’t reflect the extent of the reforms that have taken place, and say stocks have further to rally.
Abenomic’s three arrows; fiscal policy, monetary policy and structural reform, have dragged Japan out of permanent deflation. Economic growth statistics remain erratic, with the most recent third quarter statistics showing a contraction of 1.2% year on year. Few are predicting a recession, but it means that Abe has little room to back-track on his stimulus policies.
Japanese Firms Clean Up their Act
Abe’s reforms have had a significant impact in the corporate sector. The introduction of the Stewardship Code in February 2014, and reforms initiated by a variety of policymakers including Japan’s FSA, the Ministry of Economy and the Government Pension Investment Fund have seen Japanese companies improve corporate governance and balance sheet efficiency, while paying higher dividends.
They are also improving profitability. Chris Taylor, manager of the Neptune Japan Opportunities fund, says: “Japanese companies are producing record aggregate profits and profits growth. There’s no reason for that to stop or slow down because what drives Japanese corporate profits is global economic growth rather than trade growth.
“You have a 3:1 gearing on global growth, so if you get 1% global growth, you get a 3% uplift in aggregate Japanese corporate profits…the reality is that global growth is still steaming along, which benefits Japanese companies disproportionately.”
Yet this is not reflected in valuations. Rob Burdett, joint head of multi-manager at BMO Asset Management, says: “The market is cheaper today than when Abe came to power, in spite all of his reforms. While people might have hoped that the arrows would fly a little faster, they have undoubtedly worked.”
Investors Wary of Japan’s Gains
Why does the market remain cheap? Partly it is simply a legacy of Japan’s wilderness years, when deflation was endemic and corporate profitability weak. Some investors struggle to believe that it has changed. Another problem, says Burdett, is that it can be treated like the ‘ATM of Asia’.
“It is the most liquid market in the region and therefore tends to be the first port of call for investors taking down their Asia weighting. This means it gets blown about by global sentiment. For example, it dipped 8% on news over Brexit even though it is barely relevant for the Japanese market,” he explains.
It also reflects concerns over global growth. For the time being, global growth is standing firm at around 3.7% for 2018 and 2019, but many fear that once the impact of the US tax cuts dissipates and the withdrawal of global liquidity starts in earnest, global growth will slow. This is a possibility but is by no means certain and Japanese valuations leave some room for weakness.
At the same time, Japan remains an open economy and is a potential casualty of the trade war between China and the US. A Reuters poll in September found that a third of Japanese companies are affected, worrying about the prospects for their exports from China as well as slower Chinese demand. Although China and the US have called a temporary truce following the recent G20 summit, some Japanese companies are considering moving production away from China.
Opportunity Knocks
Burdett believes that even if the export part of the economy weakens, there are some “fantastic domestic plays” in Japan, particularly among small and mid-cap companies. There are also industries where Japan has a particularly strong presence, such as robotics, which are difficult to find elsewhere. Burdett is overweight Japan across his multi-manager portfolios.
Japan may not have go-go growth, but the economy is undoubtedly in better shape than it was when Abe took power and this is not reflected in valuations. Corporate reform continues to be a major spur for the Japanese stock market. Dividend pay-outs are increasing, but have some way to go. In the end, this, more than economic growth, may prove to be the catalyst to realise value in the Japanese stock market.
