Week 12: Japanese Equities


Week 12

Japanese Equities

Headwinds turn to tailwinds as improving structural factors support a bullish view towards Japanese equities in 2017.

Over the years, the Japanese economy has faced many macroeconomic headwinds. This year, many of them have turned into tailwinds. Improved Purchasing Managers’ Indexes (PMIs), accelerating wage growth and the announcement that the Japanese government will expand fiscal spending for the first time in three years all bode well for the strength of the economy.

Assisted by higher export volumes, Japan’s economy continued its improvement last year, recording annualized real GDP growth of 1.3% in 3Q 2016. This marked the third quarter in a row in which the economy had expanded owing to a boost in export volumes. However, this was offset by weaker domestic spending, and concerns remain that the benefits of Prime Minister Shinzo Abe’s reform
efforts have not yet reached the Japanese consumer.

So, is Abenomics doomed to fail? The goalposts always seem to be moving. Nevertheless, there have been concrete changes in Japan, with an improved labor market and better corporate governance. Then there is inflation. Japan has been stuck in deflation for most of the past two decades and it was even anticipated that after few years of positive consumer price index growth, the economy would sink again into deflationary territory.

However, in all likelihood, inflation may actually accelerate this year given the weakness of the yen, a potentially inflationary environment in the U.S. (and elsewhere) along with rising commodity prices. At the margin this is good news for Japanese stocks and is a tailwind that frankly we have not had. It should be supportive of Japanese revenues, trickling down to Japanese earnings and
eventually to Japanese shares.

Two areas that are likely to benefit this year are retail and financials. Japanese retail companies underperformed last year, owing to expectations of a return to deflation and price competition amongst retailers. Yet with a change in both currency and inflation expectations, those things might be viewed positively for the retail sector. At the same time, with Japanese wage growth accelerating again, we believe there is room for more consumption this year. This should be good news for retailers.

Meanwhile, yield curves have steepened globally, including in Japan, which should be positive for Japanese banks and life assurance companies. In addition, we are bullish on health care for structural reasons. Japan is an aging society, which creates a natural increase in demand for health care. As Japan ages, health care companies can accumulate experience in that market, and export it to other markets around the world.

In Japan, as the labor pool shrinks and becomes more expensive, companies are increasingly seeking to outsource non-core operations, such as human resources, to specialist providers. That’s why we believe business-to-business services in areas such as outsourced HR and benefits services still have room to grow.

Thirdly, we are bullish on automation, for example, in robotics. This area will be attractive over the next 10 years because penetration of robotics and other types of automation in China and the rest of Asia is still extremely low compared with more advanced countries, such as Japan, Germany and South Korea.

China needs to climb the value chain, now that it is making more high-end technology products, so it needs to improve quality along its entire supply chain. This is especially the case as wages in China and the rest of Asia are rising, making robots more cost-effective in comparison.

Another tailwind for Japanese equities is a weaker yen, at 115–120 per U.S. dollar. The first thing to say is that yen weakness is not a requirement for Japan equities to
outperform, but it is helpful owing to its effect on corporate earnings. Prior to the U.S. election it was about 103 to 104 yen to the dollar, and depending on what actually comes out of the Trump White House it could move in any number of different directions. Still, we remain skeptical that it will weaken to as low as 125.

A final factor to be positive about is fund flows in Japanese equities. This tends to be quite short-term in nature, but there are reasons to be bullish. By the end of October last year, international investors had sold almost two-thirds of what they purchased since the start of “Abenomics.” Meanwhile, the Bank of Japan will be buying 6 trillion yen of Japanese equities annually, while corporate share buybacks have been robust, hitting 5 trillion yen in 2016 and can be expected to continue apace this year.

At the same time, domestic pension funds are short of their target allocations for Japan, all of which combined means there is likely to be around 10 to 15 trillion yen of domestic buying into the asset class this year.