This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
China: Biting Change Creates Opportunity
Charles Sunnucks, fund manager, Jupiter China
This year has been one of material reform in China: policy makers have rolled out biting change within the financial sector, there has been tightened regulation around online activity and a continued reduction of excessive supply in key industries. These moves, against a background of uncertainty over the trading outlook for the country, has had a clear effect on domestic confidence, putting pockets of the economy under pressure.
China, however, has a highly diverse economy, so while change can be a challenge, it also creates opportunities. The overhaul within the financial sector, for instance, will likely create material stress on some business models, but is also likely to mean more deposit and lending opportunities for firms already in-line with regulation. Similarly, for online commerce platforms, new requirements on merchant registration and ‘shared liability’ on products sold is a sizeable risk for certain sites, but an overdue tailwind for those with already evolved risk processes.
More broadly, ongoing supply reductions driven by rising standards will materially harm some businesses, and yet for others it supports an improving competitive landscape and more pricing power.
In our view, these changes are far from reflected in equity valuations. We are going into 2019 with a less supportive macro-economic backdrop, but we believe the increasingly divergent outlook within China’s corporate universe should gradually be reflected via a decoupling in valuations across the market.
This will likely be most apparent in the small and mid-cap part of the market, where considerable underperformance has created several highly attractive bottom-up opportunities.
Japan: Avoiding the Global Slowdown
Dan Carter, fund manager, Jupiter Japan Select
In a climate of rising US interest rates and mounting trade tensions, talk of a global economic slowdown fills the airwaves. For Japan, we need to consider the degree to which the country may participate in this next down-cycle whenever it comes. The answer to this question may lie in the changes we have seen in Japan over the last 10 years.
First, Japanese companies hold much less debt on their balance sheet that they did when they entered the global financial crisis. In December 2007 the overall net debt to equity for the TOPIX index was 1 times whereas as now it stands at just 0.1 times with more than half of Japanese companies outside of the financial sector in a net cash position.
In addition, the proportion of Japanese book value which is tangible – i.e. consisting of physical assets, is considerably higher than other global markets, notably the US. By rights this greater financial stability should be to Japan’s benefit in the next downturn.
Second, corporate Japan is much more profitable than 10 years ago. Japanese companies walked into the last crisis with an aggregate pre-tax profit margin in line with previous peaks, of around 4%. Today that number is above 6% and, we believe, the result of structural improvements in the corporate sector rather than merely due to the strength and length of the cycle. We would argue that these structural improvements should stand Japanese companies in good stead when the cycle turns, and that the next trough in profits is unlikely to be as deep as the last.
Thirdly, through the adoption of formal codes for corporate governance and stewardship Japan has sown the seeds for better executive behaviour. The spectacular downfall of Nissan’s talismanic Chairman Carlos Ghosn stands as a stark counterpoint to the broader market which is strengthening governance structures and moving towards more shareholder-friendly policies.
Finally, a much overlooked but equally important factor has been its improving trade relationship with China. From 2011, trade between the two countries had been in the doldrums as politics – particularly the 2012 spat over the Senkaku Islands - stood in the way of economic cooperation.
Recently, however, Sino-Japanese trade has been on the rise and the rhetoric between the two nations has been increasingly friendly and trade-focused. It is not unreasonable to expect that a continued normalisation of relations, and associated uptick in trade between Japan and China, could help soften the impact of the next global slowdown.
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