As Japanese households and companies wake up to the return of inflation for the first time in 40 years, investors should be prepared, explains Adrian Hickey, head of Japanese equities, Pictet Asset Management.
Marco Polo, in his memoirs, presented Japan as the land of gold. Whether Marco Polo ever set foot in Japan, or Zipangu as he called it, remains unknown. But his account led his fellow Europeans to believe in the country’s abundant wealth and riches.
Fast forward to 2023, and Japan is still the land of opportunity. Following two decades of stagnant prices and wages, Japan has seen the return of inflation, which should prompt a normalisation of monetary policy (leading to a stronger yen) and trigger a rerating of its equity market indicating buoyancy. But what does this mean exactly? Well, due to inflationary pressure the Japanese economy is witnessing price hikes on goods and services across the board, impacting everything from soy sauce, beer, kitchen appliances and ski lift passes. Core inflation hit a 41-year high of 3.7% in December 2022.
Following December’s high inflation, the Bank of Japan (BOJ) has started edging towards removing its contentious Yield Curve Control (YCC) policy which has been criticised for distorting the yield curve, draining market liquidity and fuelling a plunge in the yen which inflated the cost of raw material imports. This change in tactics is the BOJ’s first step towards ending its negative interest rate policy.
It seems that BOJ will gradually shift the upper band of 10-year yields, currently at 0.50%, in two to three steps, before scrapping YCC altogether.
The combination of policy normalisation and mild inflation is a potent mix for Japanese equities. International investors should see the opportunity driven by Japan’s cash-rich companies and confident management teams. With real rates likely to remain negative, Japan’s economy should register the fastest rate of growth in the developed world this year of 1.5%, fuelled by a rise in investment and spending by cash-rich companies and households.
“The combination of policy normalisation and mild inflation is a potent mix for Japanese equities”
Under these conditions, investors can expect corporate earnings growth to gather speed and earnings multiples to expand. All of this suggests Japan’s equities should be a more prominent feature of a global equity portfolio.
International investors have been underweight Japanese equities since 2005, but their allocation is beginning to edge back towards the benchmark weight (EPFR Global and MSCI, data as of 30.11.2022). We expect Japanese equities to deliver an annual return of over 10% in the next five years, outperforming US equities and almost matching returns from emerging equities in dollar terms yet with far lower volatility. This is thanks in large part to the yen appreciation we anticipate over the period, but it also reflects Japan’s spending power and its impact on returns.
The country’s corporate sector is flush with cash. The cash-to-revenue ratio stands at its highest level in more than half a century, and companies are still generating even more cash with similarly record levels of free cash flow.
The level of confidence among company management (plus the amount of cash on companies’ balance sheets) is highlighted by the record level of shareholder returns, with both dividends and share buybacks expected to reach new all-time records for a combined return of JPY25 trillion.
Wage inflation could also help finally unlock the potential of Japanese households, whose consumption accounts for more than half of the country’s GDP. Japanese household savings are at their highest in at least 22 years at JPY76,700 per worker per month while their income levels are also at the highest since 2000s.
Although sceptics might argue that the currency appreciation that comes with higher interest rates bodes ill for Japanese companies and their shares, I believe that the yen will strengthen. This strengthening will move the yen closer to its fair value.
“Wage inflation could also help finally unlock the potential of Japanese households, whose consumption accounts for more than half of the country’s GDP”
Furthermore, the negative correlation between Japanese stocks and the yen has only held for a period from the late 2000s and is no longer the case. Japan’s earnings prospects are not as dependent on export growth as they used to be. The exports of goods and services contribute less than 20% to the country’s economic output (World Bank). What is more, Japan’s share in global exports has halved to 3.4% since 1998 as production moved offshore (Ministry of Finance).
Companies that are sensitive to increases in capital spending and consumption are likely to benefit the most from the new environment of rising prices. They include machinery, factory automation, housing and retailers. As for banks, which tend to benefit from tighter monetary conditions, we are beginning to take profits as the sector has already gained nearly 50% since the beginning of last year (Refinitiv).
As Japanese households and companies wake up to the return of inflation for the first time in 40 years, investors should be prepared for a radically different economic landscape, where a virtuous circle of rising prices and higher spending and investment boost the country’s stocks.
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