Japanese financial markets have established something of an unjust reputation for disappointing investors over the last three decades. Government bonds (JGBs) have been dubbed the “world’s greatest widow-making trade” while many investors think of the country’s equity market as crashing spectacularly in the late 1980s and never quite recovering, despite many false dawns. Both of these assertions are beguiling.
The term ‘widow making trade’ actually relates to the short-selling of JGBs (ie betting that yields had to rise from depressed levels – after the Bank of Japan (BoJ) first implemented its zero interest-rate policy in 1999 – meaning that JGB prices would inevitably fall). Of course, since the great financial crisis (GFC) investors in Western markets have also tried to position themselves in preparation for a so-called ‘normalisation’ of monetary policy that has, thus far, fully failed to materialise; as the latest reversal in Fed policy illustrates only too clearly. The only real difference between the two scenarios is that short sellers of JGBs underestimated the fierce sense of loyalty among local investors, who continued to accumulate long JGB positions despite anaemic yields. Similarly, the BoJ has proved unstintingly supportive of the government’s reflation efforts, especially under the stewardship of Governor Kuroda.
Moving on to the second assertion…is it really accurate to state that Japanese equities have never fully recovered from the extreme setback of the late 1980s?
Chart 1: Performance of MSCI Japan Indices
Past performance is not an indicator of future performance and current or future trends.
One notable dynamic that we have observed in recent years is that Japanese equities have become progressively cheaper regardless of overall market directionality. Occasional market selloffs have been driven by nervous sentiment which is at odds with improving fundamentals. Similarly, during the Abe-inspired rally of 2012-2018, rising equity prices failed to keep pace with growth in corporate earnings. Consequently, while US market commentators talk in terms of the S&P 500 index not being as expensive as it has been at certain times in the past, we can point to Japanese equity valuations that are compellingly attractive; the market is currently trading at price / earnings (P/E) multiples lower than those witnessed during the GFC and at the time Shinzo Abe swept to power. Justifying this on a fundamental basis is proving an increasingly difficult task, given positive developments at both the micro and macroeconomic levels.
In 1979, the British musician, Ian Dury, penned a song with the enigmatic title “Reasons to be Cheerful, Part 3”. When we consider the prospect of investing in Japanese equities, relative to their global counterparts, we can cite at least three reasons for Japanese equity investors to be cheerful in our view.
Firstly, Japanese corporations are generating historically high profits and margins. A tight labour market bodes well for income growth, which is likely to boost consumption further. As such, the rising trend in profits and margins appears likely to continue.
Secondly, since profit margins and cash flow are so healthy, Japanese corporate executives have much more room to manoeuvre in terms of capital expenditure plans, which can potentially foster further business growth, and drive adjustments to capital deployment policies in favour of returning cash to shareholders.
Thirdly, dividend yields continue to rise; as illustrated in chart 1, reinvested dividends are a particularly important component of total equity returns in Japan.
We are often asked to describe how the corporate landscape has changed since the 80s boom years and, again, we draw significant encouragement from a number of these adjustments.
While, Japan has remained at the forefront of innovation in robotics technology – it has even been argued that robotics development could potentially overcome the nation’s challenging demographics – the country’s reliance on technology exports has declined massively over the last three decades. In an era in which the extraordinary inflation in the prices of the so-called FAANG stocks in the US is the subject of heated debate, Japan’s equity market is substantially ‘underweight’ technology and banks relative to global benchmarks.
Today, the Japanese stock market enjoys a much more balanced skew towards manufacturing and consumer-related sectors, such as industrial goods & services, autos, personal & household goods and telecoms. Although we continue to find conviction in our selected technology-related holdings, the fact the broader market is less exposed to the technology and services sectors (which could be the subject to global regulation) can only be interpreted as a positive.
For the time being, the investment case for Japan is firmly rooted at the micro level, where skilled investors can uncover the niche players which may offer sustainable earnings growth at a reasonable price. From a valuation perspective, it is well worth pointing out the fact that Japanese corporates are currently enjoying the highest profitability, while share price performance remains anaemic. This, in turn, brings the ‘equity risk premium’ (or the excess return that investing in Japanese equities provides over and above the ‘risk-free rate’) to its highest level in over 40 years. All the more reason, in our view, to consider the prevailing opportunity set in Japanese equities.