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Japan: Are its well-known deterrents still justified?

30 August 2018

The investment community has exhibited long-held concerns towards investing in Japanese equities. GAM Investments’ Ernst Glanzmann and Reiko Mito examine some of these so called ‘deterrents’ and considers whether there are also some opportunities to be found.

After a long period of being relatively unloved, asset allocators have started to increase their weighting in Japan equities. According to Bank of America Merrill Lynch’s 2018 fund manager survey, the proportion of those questioned who wish to ‘overweight’ Japan has risen to 14%. That said, an overall air of caution persists as the investment community continues to worry about the nation’s challenging demographics, an economy that is mired in anaemic growth and a debt-to-GDP ratio that is approaching stratospheric proportions. So are investors right to remain cautious? We consider some of the ‘deterrents’ to investing in Japan.

Psychological deterrents

Ageing population: First, it is important to recognise that the demographics are challenging, but this is something the government is only too aware of and is seeking to address. Shinzo Abe has been very vocal on the issue of female employment and the level of women in the labour force is rising steadily. In our view, it is essential that a nation which is opposed to immigration can mobilise its domestic labour force.

Chart 1: Japan - Labour force: percent female

Source: and is the latest available data at the time of writing.

Debt to GDP ratio: Currently standing at around 253%1, this is a truly eye-watering number. However, it can be argued that excessive levels of debt are more of a problem in the eurozone, where the lack of individual central banks operating at the country level means that there is no ‘purchaser of last resort’ for government bond issuance. Furthermore, as the IMF points out2, domestic Japanese investors exhibit a very strong home bias and their appetite for Japanese government bonds, despite paltry yields, has allowed the public sector to finance extreme levels of debt and fiscal deficits without any adverse impact on funding costs.

Chart 2: Japan's eye-watering government debt to GDP ratio

Source: Trading Economics and is the latest available data at the time of writing.

It is also worth pointing out that there is a culture of thrift in Japan, so private debt is not an issue. Conversely, a number of other economies in Asia and, indeed, Europe and North America are plagued by escalating debt in both the private and public sectors. This is significant because new empirical evidence confirms that financial crises tend to be associated with excessive private debt levels3 and ‘runaway’ private debt is frequently the catalyst4. For this reason, Japan did not make the list of the seven countries most vulnerable to a debt crisis published in Forbes in March 2016. Interestingly, Australia did, even though its economy has not experienced a recession for more than 25 years.

In fact, we could argue that Japan is a ‘wealthy’ nation. The net value of assets held by the government, businesses and individuals stood at 328 trillion yen as at December 20175. This means Japan remained the biggest creditor nation for the 27th straight year5 which helps to explain why the yen is perceived as a safe haven in times of crisis.

Anaemic growth: After a ‘lost decade’ or two, the fact that Japanese economic growth remains at low levels is often cited as the number one reason for not investing in the equity market. However, while this is a curse at the core, low growth is actually a blessing at the root. While other countries grapple with the economic rattlesnake of private consumption having been borrowed from the future courtesy of low interest rates, the Japanese government simply needs to encourage the population to stop deferring purchases that they can easily fund from savings right now. Some might say this is a nice problem to have.

Consequently, the challenge is for Japanese officials to get inflation up towards its target level. While the tools of unconventional monetary policy appear to be all but exhausted, government policy may yet provide the solution. According to an academic research report commissioned by the IMF6, economic policy uncertainty has a significantly adverse effect on output, employment and investment. So, the big hope for the Japanese economy is that a comprehensive Abenomics-reload package can finally deliver economic lift off.

In the meantime, the corporate landscape in Japan remains surprisingly vibrant for those adventurous enough to scratch beneath the surface.

Genuinely innovative

Japan’s reputation for a lack of innovation is something of a new phenomenon. While it is admittedly the home of some former consumer giants that have failed to adapt to the digital age, the country’s record for outstanding innovation is impressive. Japan’s infrastructure is virtually unrivalled, as visitors to the 2020 Olympic Games will soon be able to attest. The world’s first high-speed (‘bullet’) train was invented in 1964, shaving 2 hours and 40 minutes off the near seven-hour journey time between Tokyo and Osaka (550km). The modern bullet train has reduced the journey time by an additional 105 minutes to just over 2 hours, while the new Maglev train service, planned for 2027, will halve the journey time again to little more than an hour.

Japan has also been at the forefront of innovation in robotics technology from the outset. Indeed, it has been stated that robotics development could potentially overcome the nation’s challenging demographics. The DER 01, the world’s first truly human-like Robot, was unveiled at Osaka University in 2003, while, more recently, a hotel with personnel comprised almost entirely of robots was opened in Nagasaki in the summer of 2015.

Consequently, the Japanese culture for thrift has unfairly been cited as an obstacle to innovation. Although the otherwise laudable traits of stability and corporate loyalty can serve as impediments, Japanese investment in research and development (R&D) has consistently proven stronger than that of nearly all other industrialised nations in both absolute and relative terms. According to analysis undertaken by the OECD, Japanese government expenditure on R&D as a percentage of GDP exceeded that of the US, China, Germany, the UK and France over three separate annual snapshots measured in 2005, 2010 and 2013.

Compellingly cheap

In a further encouraging development, Japanese companies have steadily, albeit at a fairly pedestrian pace, been making progress with corporate governance. Expectations were high in this respect when Shinzo Abe came into office, but the sheer number of vested parties ensured that the initial stages proved challenging. Now it is evident that management teams are really focused on improving return on equity and this was expected to surpass 10% for the first time ever for the fiscal year ending 2017. In addition, a number of companies are also looking to raise shareholder value through a combination of sustainable dividend payments and opportunistic share buybacks.

Also, notwithstanding relatively uninspiring GDP numbers, Japanese corporates are, on average, generating growth in earnings per share of around 7-8% per annum over a three-year cycle, rather than stagnating as many infer. Lots of companies are experiencing growth and the improvements in corporate governance should benefit investors in terms of returns on equity. At this stage, these positive developments have yet to be factored in to share prices – valuations remain attractive with a forward earnings multiple of 12.9x (16.9x in the US).7

For the time being, the investment case for Japan is firmly rooted at the micro level, where skilled investors can uncover the niche players that may offer sustainable earnings growth at a reasonable price. However, if the population can be persuaded to reallocate some of their savings towards deferred consumption, the outlook for corporate profitability would become very exciting indeed.

Finally, should investors increasingly appreciate that the widely-touted ‘deterrents’ of challenging demographics, excessive debt accumulation and anaemic growth are being overstated, a tide of capital flows could drive a substantial upward rerating of the market in overall terms.

1. Trading Economics – data relates to the calendar year of 2017 and is the latest available at the time of writing.
2. IMF: Japan ‘Selected issues’ (August 2016).
3. Fiscal Monitor: ‘Debt – use it wisely’ (October 2016).
4. Democracy Journal: The private debt crisis’ (September 2016).
5. Reuters (May 2018).
6. IMF Working Paper ‘Reflating Japan: Time to get unconventional?’ (August 2016). ‘Japan’s start-up ecosystem: From brave new world to part of syncretic new Japan’ Kenji Kushida (September 2016).
7. ‘Global Index Briefing: MSCI Forward P/Es’ Yardeni Research (August 2018).

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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not an indicator of future performance and current or future trends.

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