The first-half of 2017 proved encouraging, particularly with the yen stabilising at a level below that assumed in conservative corporate profit forecasts. However, Japanese equity indices broke decisively out of established trading ranges and continued to perform strongly throughout the autumn. In our view, this is long overdue recompense for the socioeconomic accomplishments we have witnessed since Abe’s succession in 2012.
Under governor Kuroda’s pragmatic leadership, the Bank of Japan has collaborated with the government to support economic recovery. We have also seen a doubling of tourism over the last three years (tourists now account for 1% of Japanese consumption) and a loosening of permit requirements for foreign residents (the number of which increased by 7% year-on-year in March).
At the corporate level, we have seen a change in mindset from company management, with pricing power returning at the product level and a new willingness to embrace wage hikes (2.0%+ in each of the last three fiscal years). This partly reflects a substantial uplift in business sentiment, which hit an 11-year high in November.
Meanwhile, the Corporate Governance code introduced by the Abe administration in 2015 has resulted in more diversity at the board level, with 99.6% of firms (44% a decade ago) now using outside directors. Similarly, the focus on shareholder-friendliness and return on equity (RoE) is also continuing to gain traction (RoE on average is around 9% and expected to hit double digits within the next two years). Meanwhile, a reduction in the corporate tax rate (to 29.7%) with effect from the beginning of the new financial year should also help lift capex (+11.2% in FY 2017, having increased for six consecutive years).
With regard to outlook, we are maintaining a fairly bullish view as we look forward to 2018. Leading indicators are on an upward trend, valuations are attractive (earnings growth has outpaced share prices resulting in reduced price / earnings multiples), the number of bankruptcies is at its lowest level since 1990 and interest rates are subdued. We believe earnings growth should be preserved, as operating leverage (through sales increases) and improved cost efficiencies (spurred by labour shortages and leading to a review of both production lines and supply chains) filter through.
Furthermore, price hikes should more than offset increased personnel costs, with an increase in merger and acquisition activity, potentially constraining the impact of the labour shortage. In this respect, we will also be monitoring potentially increasing use of co-bots (robots able to safely work alongside humans) in the services sector. Finally, in terms of products to watch for 2018 and beyond, we are particularly excited about the potential for solid state batteries to replace lithium ion equivalents and the ongoing development of AI speaker (using voice prints to replace passwords).
We have frequently argued that the supposed inverse correlation between the yen’s exchange rate and Japanese share prices is something of a red herring, since this is something of a recent phenomenon and the economy is insufficiently export-biased to justify such an inter-relationship. However, there is no doubt that policies to re-ignite the economy have been hampered by the currency’s safe haven status, particularly in the post-crisis years. As such, investors typically think of Japan as a country where the only thing that rises is the yen.
With the exchange rate against the US dollar proving relatively stable at around or slightly north of Y110, and a stock market trading at 20-year highs, we expect institutional investors to at least neutralise their structural underweight to Japanese equities. Japan benefits from a very vibrant corporate landscape and is home to some global leaders in 21st century technology, electronic components and robotics. With many of the world’s equity indices trading at or near record highs, it is also worth bearing in mind that Japanese equities remain cheap, particularly on a price-to-book basis. Moreover, there is plenty of scope for a few more years of robust performance before we get close to eclipsing the record high in share-price indices witnessed in 1989.