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Japan: Abe’s arrows still on target

And, says Julia Faurschou, that leaves Japan in good shape to cope with a market downturn in 2019
Japan: Abe’s arrows still on target

Japanese consumers are set to get something sweet this Christmas. Chocolatier Hotel Chocolat (HOTC) opened its first store in Japan in late November – just in time for holiday trading. The store can be found in the Aeon Lake Town shopping mall in Tokyo, the largest mall in Japan. Chief executive Angus Thirlwell said the store’s first day of trading had been “hugely encouraging”, with customer engagement, media attention and sales performance “all well ahead of expectations”. The sweets retailer is now looking at ways to further roll out the Hotel Chocolat brand in Japan.

And Hotel Chocolat is not the only company looking to expand into Japan. Vaping products are proving to be popular alternatives to smoking there. This is good news for the tobacco giants such as Imperial Brands (IMB) and British American Tobacco (BATS). Both are in the process of developing their individual ranges of ‘next generation products’ that are meant to make up for the decline in cigarette volumes over the long term. The popularity of vaporisers in Japan could provide a good market to test new products and learn what makes a good vape, then replicate that success in western markets. Imperial Brands has already started to do so with its vapour product blu.

Optimism from companies looking to expand in Japan is something to get excited about. For years, the country has grappled with a deflationary environment. Businesses were deterred from investing in such an economic climate since deflation implied that any investment they made would be worth less over time. This interest from foreign investment may signal that things have started to turn around. Japanese corporate governance is also catching up with the standard across other developed economies, making investment in companies there more appealing to foreign investors.

Abenomics continues

Given prime minister Shinzo Abe’s re-election last year, it looks as though his economic policies, dubbed ‘Abenomics’ are here to stay until at least 2021-22. The “three arrows” of Abenomics – monetary easing, fiscal stimulus and structural reforms – look set to endure.

The first arrow tends to be what gets the most attention from observers. While other central banks for developed countries have scaled back or outright ended monetary easing programmes, the Bank of Japan’s (BoJ) quantitative easing (QE) programme is still going strong. The bank has been buying back around ¥80 trillion (£550bn) per year in total assets, the bulk of which has been Japanese government bonds, observes Neil Williams, senior economic adviser at Hermes Investment Management.

This purchasing pace has been so strong that it’s been buying Japanese government bonds at twice the pace of net supply. The goal is to keep the 10-year government bond yield as close to zero as possible to keep the cost of debt low. The need to do so means that the BoJ will continue to buy assets, but this ¥80 trillion may now vary depending on how much is needed to meet the low-yield target. BoJ governor Haruhiko Kuroda has indicated that quantitative easing (QE) will continue until consumer price index (CPI) inflation hits the 2 per cent target. The most recent reading was 0.9 per cent, so there’s still a way to go.

The BoJ’s steady pace of bond purchases has left few low-risk assets available on the market, as the bank now owns about half of outstanding Japanese government bonds. Mr Williams said this has forced private institutions to buy riskier assets or look overseas for safer assets, which has held down the yen.

The Japanese yen has earned a reputation for being a safe-haven currency – this status stems from how the currency fares during times of high volatility. According to Capital Economics, there have been two dozen occasions since the turn of the century when the VIX index (which is a measure of the expected volatility of the US S&P 500) has moved above its 50-day moving average by more than 10 percentage points over the course of a week. In 19 cases, the increase was accompanied by a drop in the S&P 500. And when this happened, the yen strengthened on all but two occasions. The yen also provided the greatest average return and the highest inverse correlation with the S&P 500 during the 24 periods of high market volatility, compared with 10 other developed economies.

This year, that safe-haven reputation came into question after the yen proved one of the worst-performing currencies over the summer months, falling against the US dollar, the euro and sterling. But during this time, there wasn’t much turbulence in the markets, so the yen’s safe-haven status during times of volatility still stands. Instead, the yen’s slide can be attributed to Japan’s close relationship with China, which has become the latest target of US President Donald Trump’s push for protectionism.

John Stopford, head of multi-asset Income at Investec, said the Japanese yen stands out as being “significantly cheap” and offering “naturally defensive behaviour” if equities crack, thanks to Japan’s status as an international creditor.

Japanese equities

The 2018 calendar year started off strongly. Japanese equities hit highs not seen since the early 1990s (as measured by the Topix Index). While this is encouraging, Michael Stanes, investment director at Heartwood Investment Management, cautioned investors to tread carefully. The economy has appeared unable to grow in excess of its 1-2 per cent range.

But on a corporate level, the picture is brighter. In 2015, the Corporate Governance Code was introduced by the Financial Services Agency, Japan’s financial regulator, in an effort to bring Japan closer in line with other developed countries in terms of company action. The more than 2,400 companies listed on the Tokyo Stock Exchange all fall within its jurisdiction. Some of the code’s most well-known objectives have been pushing companies to hire at least two outside directors and discouraging cross-shareholding, whereby two friendly companies hold each other’s stock. Overall, these aims are meant to encourage transparency in what was previously a notoriously opaque market for business practices.

The latest reforms have got tougher on cross-shareholding, as well as encouraging the broader adoption of compensation and nomination committees, and greater diversity on boards. Eiji Saito, fund manager on the JPMorgan Japan Smaller Companies investment trust, said that improving corporate governance is resulting in “steady increases to both dividends and share buybacks”, as well as a rise in the number of outside directors sitting on company boards. Companies have become more transparent at explicitly specifying returns on equity and asset targets.

Corporate governance reforms appear to be having an impact, as does the government’s encouraging of companies to boost returns. Share buybacks have become an increasingly popular way for companies to absorb some of the excess cash they have built up on their balance sheets. Buybacks, while still modest, are up 37 per cent year on year. Corporate activity in the form of takeovers and mergers has also been picking up, which Mr Stanes thought perhaps reflected the greater presence of foreign shareholders.

Overall, cash flow has improved and so businesses are now increasing capital expenditure with a focus on sustainability of operations, according to Joël Le Saux, manager of the Oyster Japan Opportunities fund at SYZ Asset Management. He thinks this bodes well for productivity in the long run and that the average Japanese price/earnings (PE) ratio of 12.5 times does not adequately reflect these trends. To improve valuations in a sustainable way, with business margins already at their highest level on record, companies need to improve dividend policies and enhance share repurchase programmes. The fund manager said most companies have strong balance sheets and still need to improve their payouts to shareholders.

Japan looks to have made progress on its economic goals and corporate governance reforms, but headwinds remain. Near-term hurdles include possible fallout from the trade dispute between the US and China, as well as a planned consumption tax hike in 2019 and Upper House elections next July. With talk of an oncoming downturn in the global economy, those looking to invest in Japan must consider these risks. Dan Carter, manager of Jupiter Japan Income fund, thinks that the general improvement in Japanese companies’ capital structure could be their saving grace. Japanese companies hold much less debt on their balance sheets than they did when they entered the global financial crisis. In December 2007, the overall net debt to equity ratio for the Topix index was 1x, whereas now it stands at just 0.1x, with more than half of Japanese companies outside of the financial sector in a net cash position. These companies also hold a higher proportion of tangible assets than those in other developed markets.

Corporate Japan is much more profitable than 10 years ago, according to Mr Carter. Japanese companies walked into the last crisis with an aggregate pre-tax profit margin in line with previous peaks, of around 4 per cent – today that number is above 6 per cent. Supposedly, this is the result of structural improvements rather than the benefit of the market cycle. Together this should help Japanese companies withstand any market downturn if and when it comes.

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