There is some momentum being built for investors in Japan following decades battling deflation, negative interest rates and investor disappointment. First, the equity market is rising strongly, being up, year to date, by 25% in local currency terms, as measured by the TSE Topix. This relative strength has been dampened for investors in the UK as the strength of sterling (or more accurately, the weakness of the Japanese yen) has diminished these headline levels of return. There are reasons for optimism that Japan can now prove a fertile hunting ground for overseas investors.
There is plenty going on in Japan: the potential for the central bank to alter its ultra-supportive policy could release the yen from its weak stranglehold, corporate reforms are focusing listed Japanese companies’ attention on shareholder returns, relative valuations look attractive too. However, Japan has consistently been the contrarian investor’s choice over the last 20 years. There are plenty of reasons to remain sceptical of course; not least the poor demographics, the huge Government debt burden, and the allure of other, faster growing Asian economies, but Japan remains a contrarian choice with potential both to surprise and disappoint, but also one that is increasingly getting investor attention.
Corporate Reforms – Unlocking value
The headline may not be catchy but the impact of corporate reform in Japan should not be underestimated. The focus is to release some of the underlying value in Japanese companies for shareholders where, in comparison to global peers, companies are weighed down with cash. On the one hand, cash is good for corporate health, but excess cash held unproductively and not re-invested, serves only to fatten waistline.
This has been a slow process; corporate governance reforms started with Prime Minister Abe’s reforms a decade ago but there is now a greater sense of urgency and activism by investors to drive change. The Tokyo Stock Exchange increased the pressure in January as they demanded companies trading below book value (meaning the value of a company’s equity is worth less than its assets, which is about half of Japanese listed companies) create an action plan to erase that or face the ignominy of being publicly shamed. This potentially could come through an increased number of share buyback or dividends, reducing cash piles in the process and making Japanese equities more attractive for global and domestic investors.
A supportive central bank
The Bank of Japan looks to have begun the process of unwinding ultra-loose policy. Slowly. During the summer, the BofJ shifted to a policy of flexble yield curve control, which targets a yield on the Government ten year bond at 0%, but allows the actual yield to drift up to an upper limit of 1% (double its previous target) before seeking to conduct any operations to limit the market yield.
This is all a bit technical, so the very big picture is this. After years of living with deflation, the ‘right sort’ of inflation is beginning to emerge in Japan. Rising prices and wages alongside the successful ability for Japanese companies to be able to pass on rising costs to consumers are creating an opportunity for the Bank of Japan to begin withdrawing from its ultra-supportive central bank policy.
Central bank policy has implications for the yen, which has been particularly weak versus sterling over the last year. This is partly a mix of investors selling the low yielding yen for higher yielding currencies such as the US dollar, but this ‘trade’ has become prohibitvely expensive for Japanese investors looking for a bit of extra yield as currency hedging costs have increased (particularly against the US dollar). The particular weakness against sterling is probably more driven by the ‘higher for longer’ narrative coming from the Bank of England, which has helped to sustain an elevated pound.
For UK based investors, the strength of sterling has diluted some of the returns enjoyed by domestic investors in Japan. If we move into an environment which sees a softening in central bank tone by Governor Ueda, what has been a headwind could turn into a source of positive returns for UK investors. There’s a slight caveat, which is how the undervalued yen, realises its value. A slow pace of a gradually yen appreciation driven by a cautious central bank (made even more so following the events in March, which saw the failure of some US banks mispositioned for the fall in value of its government bonds) in the face of a strongly rising US interest rate environment, would be a positive. A sharp appreciation of the yen is likely to damage the corporate earnings of a number of Japanese companies, particularly those with overseas earnings, and this would be a strong headwind to holding Japanese equities.
A better port in a storm?
Despite the year to date rally, Japanese equities still look relatively attractively valued versus global peers and the prospects for strong corporate earnings growth continue to look more positive going into next year. The TOPIX index, which covers the broad range of Japanese listed companies, still hovers around its 20 year median average valuation, so neither cheap nor expensive versus recent history. The prospects for corporate earnings growth should find a healthy foundation as inflation in Japan sustains itself, allowing companies to have the pricing power they haven’t enjoyed for years. This should help underpin valuations without accounting for any of the benefits of corporate reforms that Japanese companies are attempting to deliver.
Fall down seven times, get up eight
So, whilst the stewards of market history may well serve us well by reminding us of the perils and pitfalls of investing in Japan, there remain some key factors that warrant attention above and beyond just the ‘hope’ of recovery: the appetite to drive corporate reform to release broader market value, a supportive central bank policy cautious not to unsettle markets, a currency that looks in the doldrums alongside valuations that do not look stretched. These are all potential tailwinds and could well lay the foundation for some near-term outperformance to become more sustained over the longer-haul.