Magazine issues » Summer 2015

INSIDE VIEW: A turning point for Japan?

Mount FujiJapan fell into recession last year, but Gael Combes of Unigestion says the economy will be stronger in 2015, especially for companies focused on domestic consumption.

After almost 20 years of gloom, the election of conservative prime minister Shinzo Abe in 2012 created new dynamics for Japan’s economy. His election saw a shift in policy known as Abenomics, which has dramatically altered the currents of Japan’s financial flows. 

It comprises three metaphorical arrows: monetary stimulus, fiscal stimulus and structural reform. The first arrow was fired within months of his election with a massive quantitative easing programme from the Bank of Japan.

There have been several consequences of Abenomics two years on: the yen has declined dramatically; Japan’s international competitiveness has increased thanks to the yen’s decline; the job market has improved; and company earnings have increased significantly.

These present a rosy picture for Japan’s economy, even though 2014 proved challenging (the country experienced a recession after negative growth in the second and third quarters).

DARKNESS AND LIGHT
The cause of the recent economic malaise is easy to diagnose. Widescale government spending that formed the ‘fiscal stimulus’ arrow was supported by VAT being increased in several steps. The first hike from 5% to 8% came in April 2014 and had an immediate short-term negative impact on Japanese growth. Furthermore, when combined with a weakening yen and rising short-term inflation, Japan’s purchasing power declined. As a consequence, so did consumption.

We expect 2015, however, to be a much brighter year for Japan. The first positive effects from these measures since they were taken up should be felt from here on. No tax increase is planned this year – it has been postponed until 2017. 

Additionally, the yen has started to stabilise, while the policies of Abenomics incentivises companies to convert increases in margin into increases in wages. This has already started since the end of 2014. Furthermore, import inflation will weaken in 2015 thanks to a weaker yen as well as lower commodity prices, especially oil.

Therefore, the purchasing power of Japanese workers should rise in 2015 and increase domestic consumption – a reversal of 2014. 

Japan’s economy has been trending positively since the final quarter of 2014. We expect this momentum to help GDP growth to beat expectations this year.

ECONOMIC CYCLE
The weak yen and good health of Japanese industries present an optimistic outlook for Japanese equities. Further support for Japan’s equity market could come from additional accommodative measures from the Bank of Japan, which is likely to miss its inflation target in 2015.

There has been a general indifference to Japanese equities since the 2008 financial crisis. However, Shinzo Abe’s government has offered strong incentives to companies to increase their profitability by either restructuring parts of their business, favouring mergers and acquisitions or distributing greater dividends to investors.

All these actions are likely to increase the return-on-equity for Japanese stocks and strongly support current equity prices. Moreover, the US and Europe’s equity markets have average valuations significantly above their cost-of-equity, while Japanese equities appear cheaper with a valuation level in line with their cost-of-equity.

In addition, since mid-2014, the MSCI Japan index no longer underperforms the MSCI World (both indices are priced in US dollars). This trend signals that Japan has good momentum behind it, as we have seen since the beginning of 2015.

BE CAUTIOUS
Having described where Japan is in the economic cycle and the strengths relating to Japanese equities, it is important to also look at the market’s weaknesses. Most of these are structural and are linked to Abe’s ‘third arrow’ of reform.

Japan has the largest debt burden in the world, representing more than 240% of its GDP. It still faces a huge budget deficit despite greater fiscal revenues since the VAT increase – there is still a lot to improve to balance the budget, especially in public spending. The country has a major demographic problem which the government needs to address – the working-age population has been in decline for the last 20 years.

Another factor to consider is the relative performance of export-led and domestic-orientated companies. Japan’s stock market recovery was initially driven by exporters who benefited from the depreciation in the yen, which bolstered their earnings. Looking ahead, however, pressure on the Japanese government to increase wages through policy action will benefit companies closely linked to domestic consumption.

STRATEGIES
The drawback of investing in a passive strategy today is that it is likely to be overweight exporters where the recovery is largely priced in. On the other hand, an active, risk-managed approach would favour firms tied to domestic consumption where future prospects are not yet fully reflected.

In 2013, we saw outperformance from exporters. In 2014, there was very little dispersion in price between stocks linked to exporters and domestic consumption due to macro uncertainties and the increase in VAT. However, at the start of 2015, stocks linked to domestic consumption have begun to outperform exporters.

Strong downside protection and lower exposure to tail risks are two more good reasons for taking a risk-managed approach. The other important reason is that investors stay fully invested for the subsequent recovery. In contrast, a passive allocation to Japan that flips to cash during market volatility runs the risk of missing or being late for the recovery – the investor loses valuable performance.

An active, risk-managed fund can carry significantly less tail risk exposure than the MSCI Japan index and can demonstrate low levels of participation during periods of drawdown. It can also participate more during rising markets and therefore display a positive return asymmetry that allows it to outperform the MSCI Japan index.

This level of participation could have been even greater since the launch of Abenomics, assisted by the low dispersion of returns in the market. As discussed earlier, we believe there will be greater divergence ahead as the market favours domestic-orientated companies over export-led firms.

We think that a tilt to domestic-orientated companies will enable actively managed funds to maintain participation in the bull market in the coming months.

Gael Combes is a fundamental analyst at Unigestion

©2015 funds global asia

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