Should investors reconsider Japan?

Darius McDermott 10/11/2022
Up to 30 minutes of CPD

The world’s third largest economy has often been avoided by global investors as it has struggled with deflation and low growth for many years. With a weakening currency and a torrid global backdrop, the outlook may not appear to be favourable at first glance, but it that the true picture? This paper explores the current position of Japan and its outlook for the future. 

Having read this article and related learning, you will have improved your understanding of the composition of the Japanese market, and to which factors it is most reactive. You will understand more about the impact of a weakening currency and how investing in Japan may differ to investing more broadly in Asia. 

30 minutes of CPD include:

  • Article: 10 mins
  • Related learning video: 13 minutes
  • Related learning article: 5 mins
  • Quiz: 5 mins

How does the global macro picture impact Japan?

For investors, there have been few places to hide throughout what has been a challenging 2022.

Inflation, energy price rises, and geopolitical tensions have injected untold volatility into both equity and bond markets, with many indices experiencing double-digit declines throughout 2022.

But what have been the ramifications for Japan, given its relative dislocation from broader equity markets? Well, the Japanese stock market, as measured by the TOPIX, has held up reasonably well, falling just shy of 8% in sterling terms year to date compared with a fall of almost 15% for the wider MSCI Asia ex Japan index*.

John Paul Temperley, a portfolio manager on the AXA Framlington Japan fund, explains: “There are two key macro factors at play currently – inflation and rising interest rates. Japan is certainly seeing cost push inflation, similar to other countries, but the magnitude is less.”

He continued, “Japanese CPI is currently rising close to 3% annually, compared to closer to 10% in many Western countries. There are a few reasons for this: Japan has upper limits to utility prices, and the government has subsidised gasoline keeping the price lower for consumers. There is no wage inflation yet, despite a tight labour market. This is likely a result of corporates favouring capital investment and increasing shareholder pay-outs rather than raising wages. This could change but it hasn’t yet.”

In other developed markets such as the US, UK and Europe, central banks have dominated the headlines, embarking on monetary tightening cycles which have seen interest rates rise significantly.

Has Japan followed suit?

“Interest rate policy has also remained stable”, said John Paul Temperley, “The Bank of Japan (BoJ) has retained its zero-interest rate policy and yield curve controls. Some commentators have questioned this when other central banks are raising rates. However, given the lower pace of inflation in Japan, and the fact that the nation is facing a severe demographic situation, the BoJ has held firm.”

In fact, rising inflation could be seen as a positive for Japan which has battled deflation for many years. Sunny Romo, investment specialist on the M&G Japan fund, tells us more on this video interview.

Related Learning: Japan is on track to deliver stellar performance; are investors ready to reap rewards?

Assessing the domestic environment

The echoes of the global pandemic continue to ring throughout Asia, which was seemingly disproportionally impacted, relative to Western economies.

With Asia unfurling at a slower pace, for the value-oriented investor, there may be an opportunity to capture the continent’s re-opening, as Chloe Darling-Stewart, Investment Specialist at Baillie Gifford, considers: “Unlike the West, Japan only fully re-opened its borders to tourists in October this year and masks are still worn both indoors and out. Year to date, there have been less than a million visitors to Japan, compared to over 31 million in 2019.”

She continues, “That being said, life in Japan is slowly returning to normal, with restaurants and department stores brimming with activity, ready for the return of tourists. In addition, cashless payments appear to be becoming mainstream (Japan has historically been a very cash-based society) suggesting some behaviours developed through the pandemic may well have stuck. As the country slowly reopens and tourists start to return (encouraged by a weak yen), there is a lot of economic activity and growth to come. These trends have already been evidenced in the earnings of several companies such as Fast Retailing, the company behind UNIQLO, which reported record profitability after its stores benefited from a recovery in footfall.”

Richard Kaye, co-manager of the Comgest Growth Japan fund added, “Japan has one of the most stable political contexts of any developed country, which has permitted remarkable consistency in areas of deregulation, corporate governance focus, growth stimulus, accommodative monetary framework and free trade agreements; consensus forecasts see Japan’s GDP growth as one of the highest among G7 nations in 2023, partly thanks to this set of policies.”

Key investors criticisms of Japan

For many seasoned investors, there have historically been two key turn-offs for investing in Japan – restrictive corporate policy and poor age demographics.

Of the former, there has been a lurch towards a more ‘Western’ approach to shareholder relations in recent years. This has been a gradual process, as the impact of the Asian financial crisis have lived long in the memory of politicians and corporates alike, but John Paul Temperley has registered a meaningful improvement: “Japanese corporates have been increasing shareholder pay-out ratios for over a decade, and at 30% are close to international standards.”

The country’s ageing population is well documented, with Japan having sat atop many such lists over the years. However, John Paul sees this as more of a global issue, with indeed, a global solution: “Ageing demographics is a well-documented issue in Japan. It is also becoming one in other countries.

South Korea now has a lower birth rate than Japan, and China is facing the biggest demographic problems due to its one child policy. Regarding Japan, immigration is slowly picking up where there are skills shortages. Nursing care and construction work are examples of that.”

He concludes, “Ultimately, productivity will need to increase to offset the fall in the working age population. Abenomics was the beginning of an evolution of Japanese government policy to address this.”

How has the devaluation of the Yen impacted Japanese equities?

Another key thread of 2022 has been the rapid depreciation of the Japanese yen, which has sunk to its lowest value versus the US dollar in decades.

For investors considering an allocation towards Japanese equities, what are the impacts of this on the equity market?

Of this, Richard Kaye said: “It has been neutral. Where exporters have gained, importers have lost. Specifically, many of our export companies currently premise 120-130 to the US dollar for their entire fiscal year until March 2023, so will raise their earnings guidance substantially when they next report.”

He continued, “At the same time, investee companies we own like Nitori, which makes furniture in dollar-linked countries, or Kobe Bussan, a supermarket operator which imports processed foods from China, have been challenged by the weak yen. However, these companies have made substantial provisions to offset this, like a comprehensive currency hedging approach at Nitori, or diversification of supplier base and a higher ratio of internally manufactured ‘Private Brand’ products at Kobe Bussan.”

On this, John Paul Temperley added, “Japan trades with the global economy, and is sensitive to global economic trends. However, the weaker yen should cushion the hit to corporate profits in the near term, and longer term should improve Japan’s competitive position. Japan has also just reopened its borders to foreign tourists and business travellers. This inbound demand was an increasingly important macro benefit to domestic demand prior to Covid. We can assume that it should provide a boost as visitors return to Japan.”

While some domestic companies have managed to provision for local currency weakness, the disparity between yen and dollar value is something investors should remain vigilant of. The BoJ made a rare intervention earlier in the year to add ballast to the currency, suggesting that there is at least some local concern over the currency’s continued weakness.

What does a Japanese equity fund offer to a diversified portfolio?

So, for investors considering an allocation to Asia, why should they consider a Japanese equity fund?

For Richard Kaye, it’s a mix of the opportunity and shared sensibility, “Hidden among the nearly 4000 listed companies in Japan are global leaders in semiconductor, automation and medical technology, as well as many companies which speak shareholders’ language with their strong sense of social purpose, their pursuit of unique businesses and their capital discipline,” he said.

Beyond that, Japanese equities may add a degree of non-correlation (to broader equity markets), as Chloe Darling-Stewart explains: “The Japanese market often moves at a different rhythm to other markets globally. It provides unique idiosyncrasies which can only be accessed through investing in domestic Japanese businesses that are typically too small to feature in global portfolios.”

“Japan is also home to some of the world’s best-known brands, many of which are primed to benefit from the premiumisation trend within Asia, from rising wealth across the region”, she continues,

“Less obvious, are the emerging class of entrepreneurs that are helping the country tackle its digital transition. Japan is unique in that despite being the world’s third largest economy, it is behind the curve in terms of digitalisation across many industries, such as ecommerce and digital payments, presenting a unique market opportunity for many years of growth ahead. Valuations, continued corporate reform, with the prospect of an acceleration in buybacks and dividends add to this attractive mix.”

Related learning: Five reasons to invest in Japan

How do Japanese equity markets differ from broader Asian equity markets?

Investors will have noticed that there are few in the way of Asia including Japan funds in the market (although they do exist), much in the same way that European funds tend to exclude the UK.

So, for investors seeking to allocate capital to the continent, what are the key differences between Japanese equities, and Asia ex Japan?

“In our opinion, Japanese equities have on average more liquidity, longer history as a listed company, stronger balance sheets, better governance as defined by most objective metrics and the benefit of a more stable political context, than their Asian counterparts”, said Richard Kaye.

“The Japanese market is broader relative to other Asian markets, with a large range of companies across the market cap spectrum”, added Chloe Darling-Stewart. “Japan is also uniquely positioned in certain areas such as premium skincare, high-tech robotics and automation and niche internet businesses. The country also benefits from an environment that is conducive to outside investment: political stability; enshrined property rights and the rule of law; fiscal and monetary easing; improving corporate reform; and cash-rich corporates and consumers.”

It’s also worth noting that while there are many diverse and exciting economies within the Asia ex-Japan space, it is somewhat at the mercy of China – the index’s largest constituent.

Outlook

So, with the global economy having endured a bruising 2022, what can we expect from Japan going forward?

“The economic environment in Japan remains benign relative to the broader world and corporates are in good health. In addition, record operating profitability, strong balance sheets, a steep climb in buybacks and increased capital spending bode well for further upside. We believe Japan continues to offer a fertile environment for growth investors, which will only expand as the region emerges out of Covid-19”, said Chloe Darling-Stewart.

This sentiment is supported by Richard Kaye, who feels that the nation’s standing as innovators puts them in good stead for the coming years: “Now, more than at any time, Japan commands our attention because it has numerous companies vital to the world’s future in semiconductor, automation, medical diagnosis or renewable energy – with what we believe to be unsustainably low valuations.”

Sunny Romo is even more bullish on the outlook. “I think that the likelihood of Japan achieving a higher growth than a lot of the developed market is quite high,” she said.

She says people have an assumption that Japan is a low-growth market. “But if you look at the last 10 years, it’s been able to deliver 10% compound annual growth in earnings. That’s per year. That’s amazing growth. And I don’t think many other markets can beat that,” she said.

What’s more, Sunny points out that this growth has occurred during a time when former Prime Minister Abe – through his reforms – was laying down the plumbing for corporate Japan to act more like profit-making businesses, to become more westernised, and really facilitate a positive change, not only on paper, but in the mentality of management.

“Now, if you think that Japan’s been able to deliver 10% CAGR [compound annual growth rate] over the last 10 years while this has been happening, there’s no reason to think that this trend won’t continue,” she concluded.

*Source: FE fundinfo, total returns in sterling, 31 December 2021 to 8 November 2022

A reminder of the Learning Objectives

  • Understand why inflation is not a problem in Japan as it is in other developed markets
  • Have a better understanding of the opportunities in the domestic market
  • Identify the factors that  have put investors off Japan in the past and why these points should be reassessed

Should investors consider Japan again?_minutes=30_

Please answer the six multiple choice questions below in order to bank your CPD.

1. How can Japanese companies mitigate the impact of a weaker yen?(Required)
2. Why is inflation lower in Japan than in other developed markets?(Required)
3. The related learning video with M&G’s Sunny Romo, what hasn’t occurred yet in the Japanese stock market?(Required)
4. What are some of the differences between the Japanese market and other Asian markets?(Required)
5. In the related learning article, what does Matthew Brett say has been the impact of a weaker yen?(Required)
6. According to John Paul Temperley, what has put investors off investing in Japan in the past?(Required)