It’s difficult to think about investing in Japan without ‘Abenomics’ immediately springing to mind, but this is not without good reason. In October, Shinzo Abe clinched his authority as prime minister of Japan. In much the opposite to what happened in the UK, Mr Abe went into the election against speculation that he would likely win but lose seats, only to walk away with a sweeping victory and the House of Representatives. Mrs May, take note.
The victory has given the prime minister the authority to pursue his ambitious mandate of economic reforms. The market appeared pleased with the outcome, as the Nikkei 225 Index is up around 6 per cent since the election result. Political stability has set the stage for Japan to possibly be a good place to consider putting your money in the new year.
Since his original victory in 2012 ‘Abenomics’ has been characterised by a combination of monetary and fiscal stimulus along with economic reforms. The aim was to revive inflation in the Japanese economy, one that has been plagued by deflation for too long. This has been no easy task and critics have been quick to call it a failure, but progress has been made.
At the most recent count, core consumer prices were up 0.8 per cent in October from 0.7 per cent the month before, but still below the Bank of Japan’s 2 per cent target rate of inflation. The country has returned to growth since Mr Abe took over, but inflation has remained stubbornly low. This low inflation, or even deflation, may not seem like such a bad thing to the average consumer since it means that their everyday goods and services remain either largely the same price or cheaper. But for investors this is all but good news, since money put into projects is likely going to be worth less in the future than at the outset. This discourages companies from doing anything at all, which creates a vicious cycle of under investment. Investors will be understandably relieved to see this trend abate.
Economic stimulus
After years of historically low interest rates, developed economies have begun to see the base rate creep back up again. State-side, the Federal Reserve was the first to make an upwards move back in 2015. The Bank of England cut rates to 0.25 per cent as an emergency measure after the UK voted to leave the European Union, but in November made the first hike in 10 years back to 0.5 per cent.
The Bank of Japan has arguably had less room to manoeuvre than some of its developed-nation counterparts due to years of stubbornly low or non-existent inflation. While others are looking to put an end to years of cheap rates and quantitative easing, Japanese policymakers have never looked more divergent from the rest of the world’s central bankers, with the base rate currently at 0.1 per cent.
Out of the three main pillars of Abenomics – fiscal stimulus, structural reforms, and monetary easing – it is the latter that is often the most talked about. The Bank of Japan has effectively flooded the market with liquidity and is now one of the largest shareholders of the Nikkei index, mainly through exchange-traded funds (ETFs) and investment trusts rather than owning equities directly. Michael Stanes, investment director at Heartwood Investment Management, said that since the Bank owns around three-quarters of domestic ETFs, the yield curve and other price setting mechanisms in Japan’s financial markets have been “nationalised”.
On the structural side, the government has passed some immigration measures to give a boost to the sluggish workforce, such as allowing highly skilled foreign workers to apply for citizenship more quickly. Childcare is more accessible as a means to encourage women into the workforce to help offset an ageing population. They’re opening the doors to tourism by opening up who can sell holidays, airspace regulation, and by translating tourist information into English.
Outlook for equities
The end to years of deflation has investment confidence in Japan on the rise. This optimism has increased the levels of capital expenditure among Japanese companies and foreign investment has returned. Together, this should help move along the evolution of Japanese companies from cash hoarding cynics to investment optimists.
Since this swing to growth and willingness to invest in projects is still in its relatively early stages, investors can often pick up Japanese shares for reasonable prices. Bill McQuaker, portfolio manager at Fidelity Multi Asset Open Funds, said “one could make an argument for investing in Japan simply based on the price”. Companies are now presented with projects that have a better outlook on positive returns, and after years of building up cash, they have the money to fund them without having to turn to external finance.
In the rest of the world, companies with large chunks of cash on their balance sheet could be susceptible to a takeover, but this normal market mechanism has been less relevant in Japan. Instead, management teams are focusing on how to make their built-up cash work more effectively, and are becoming more willing to pay dividends.
Nicholas Weindling, portfolio manager of the JPMorgan Japanese Investment Trust, called Japan’s overall outlook “looking pretty healthy” at the moment, with several factors at play which are starting to meld together. “Broadly speaking the Japanese economy is getting better, as is the global economy. Japan will stand to benefit as this continues to happen. Japan also offers investors low valuations, with price-to-earnings, price-to-book, and dividend yield all looking good compared with other developed markets,” Mr Weindling said.
Stock picks
Japanese companies achieved record high earnings in fiscal year 2016, and in aggregate are likely to deliver a higher earnings level once the 2017 fiscal year comes to an end. Earnings estimates by analysts have continued to be revised up in 2017, giving Japan the strongest rate of upgrades of any major market. JPMorgan’s Mr Weindling said he’s found compelling investment opportunities in structural growth areas such as the growth in the penetration of e-commerce, automation, Japan’s ageing population and companies prioritising improving shareholder returns. “One of the key reasons we focus on long-term structural growth names is that they tend to be less sensitive to the yen to dollar exchange rate. We also find strong investment opportunities in new Japan brands that are growing globally, whose products stand for reliability, quality and safety.”
One example is Shimano (Jap:7309), a manufacturer of bicycle parts sold globally. It has high market share, with growth driven by the increasing popularity of cycling as a leisure activity in developed markets, and sales to the expanding emerging markets middle class. It has also benefited from customers trading up to higher-quality bicycles. Smaller competitors have struggled to match its investment in developing new products. The key risk to the thesis is that demand in some areas such as China is cyclical rather than structural.
He also pointed to Japan’s number one apparel e-commerce operator Start Today (Jap:3092) on the basis that the company still has a good growth outlook given low penetration rates in Japan, improving product range as more stores join the platform – in turn attracting further custom – and as established ‘bricks and mortar’ retailers struggle to adjust to this new business paradigm.
The entrepreneurial spirit in Japan is not dead, according to Heartwood’s Mr Stanes, and there are a number of attractive opportunities to exploit, independent of the wider economy. “We consider these are best accessed through active managers who have a specific tilt, whether in smaller companies and/or in the more value-orientated parts of the market. We aim and believe it is necessary to be very specific about the investments we make in Japan.” If the uptick in inflation sticks around then a rise in interest rates could not be far off. Fidelity’s Mr McQuaker reckons that Japanese banks could be the big beneficiary of a return to economic growth and inflation. Before, low interest rates had made it hard to make money on Japanese banks, but growth could mean interest rates could go up, which could imply “quite a lot of upside”.
Edward Smith, head of asset allocation at Rathbones, appears to agree – but only to an extent. He thinks that reflation may not yet be priced into the shares of banks, “so not much downside risk there”, but noted that it could be “slightly premature” to forecast an end to deflation for good. No matter which sector of the economy you’re after, Mr Smith said many companies were still not run in the best interests of shareholders, so going with a good active manager could help minimise the risk of choosing poorly run companies.
Inflation may still be stubbornly low, but progress has been made. Japan looks less and less likely to slip back into deflation, which is good news for corporations and should help the country break out from the vicious cycle of underinvestment. Political stability makes this all the more likely to come through, making investment in Japan a good growth prospect for the new year.
