Japan: a leveraged play on global growth?

Japan’s nascent economic recovery is showing encouraging signs, with some strength in the labour market and a favourable corporate environment. However, domestic demand remains weak and it appears that cultural headwinds will have to be addressed before a virtuous circle of rising domestic demand and inflation can begin. Meanwhile, Japan’s asset markets are being distorted by policy and this presents unique challenges for investors.

A two-speed economy

Japan’s unemployment rate is falling, despite already being at its lowest level since the early 1990s. However, this statistic is somewhat misleading as the number of employed persons in the country is roughly the same as it was when unemployment last peaked in 2009; this is because the workforce is undergoing a structural contraction as the population ages. To improve the situation, Prime Minister Shinzō Abe’s ‘Abenomics’ programme included a number of reforms designed to increase labour-market participation and boost the size of the workforce (Figure 1). These appear to have had some positive effects, with an increase in the number of employed persons since their implementation in late 2012.

Although falling unemployment has helped the labour market tighten in areas, overall wage growth continues to be held back by cultural factors, such as a lack of turnover in the job market. Furthermore, multinationals in Japan’s large export sector are generally granting only minor wage increases in this year’s annual Shuntō wage negotiations amid concerns surrounding Donald Trump’s trade policies, rising costs and the strengthening of the yen in 2016. As such, it appears unlikely that there will be an immediate and persistent rise in wage growth.

Weak wage growth and adverse demographic changes continue to put pressure on domestic consumption, despite the moderate growth of the workforce in recent years. This is evident in household spending data, which has showed continued contraction for over a year, and retail sales growth which remains subdued. In turn, a lack of domestic demand growth is the major factor undermining core inflation, which remains very weak despite having moved back into positive territory in 2017 (Figure 2). Nevertheless, the Bank of Japan (BoJ) is hopeful that it can break Japan’s deflationary cycle, whereby expectations of falling prices cause consumption to decline as consumers delay spending plans.

For now, low core inflation is allowing the BoJ to keep monetary policy highly accommodative. Its policies have caused the yen to weaken, boosting overseas demand for Japanese goods and services; we note that strengthening global demand has also been beneficial to Japan’s export-orientated economy. These factors are evident in the Japanese activity and sentiment surveys, such as purchasing managers’ indices and the closely-followed Tankan business conditions survey, as well as the country’s encouraging industrial and manufacturing production growth rates. Although domestic demand remains weak, this backdrop is highly favourable for corporate performance and, therefore, Japan’s equity market.

Fig 1Figure 1: Although Japan’s unemployment rate has been in decline since the global financial crisis, the workforce has only been growing since 2012, when Abenomics reforms were introduced to encourage greater workforce participation. With the unemployment rate now at very low levels, growth in total employment will depend on greater participation.
Source: Thomson Reuters Datastream

 

Fig 2Figure 2: Although bouts of yen weakness have temporarily boosted Japanese inflation when they have occurred in recent years, weak domestic demand has ensured that any periods of higher inflation have been transitory.
Source: Thomson Reuters Datastream

Monetary policy and the yen

Although investors were losing faith in the BoJ’s ability to weaken the yen in early 2016, the move to its current monetary policy framework of ‘Quantitative and Qualitative Monetary Easing with Yield Curve Control’ (QQE) caused the currency renewed weakness in the latter half of the year. This was because the framework’s premise is to maintain 10-year Japanese government bond yields at 0% at a time when yields elsewhere in the world were rising. We do not expect the BoJ to change its policy stance for some time and therefore expect Japanese government bond yields to remain relatively stable in the near term.

With Japanese interest rates (both real and nominal) expected to be relatively stable, overseas factors will determine the direction of the yen in the coming months. These will include global risk sentiment, China’s economic performance and the movement of global bond yields, which will depend on growth, monetary policy expectations and political developments. Given that the yen and overseas demand are such large drivers of Japanese corporate performance, we expect the country’s equity market to act as a leveraged play on global growth expectations over the next 12 months.

Not only monetary policy…

Much was made of the potential for corporate reform to re-invigorate investors’ appetite for Japanese equities in the years immediately following the introduction of Abenomics. However, slow progress in this area tempered investors’ hopes that improved corporate governance could increase investor returns. As per the headwinds to wage growth in the labour market, many of the hurdles to improved corporate governance are cultural.

There remains significant potential for corporate reform to improve Japanese equity-market returns. Japan’s dividend payout ratio is lower than any other major equity market, despite corporate cash balances being much higher (Figures 3 and 4). Furthermore, the weakening of the yen and low wage growth are likely to strengthen Japanese corporates’ financial positions over the next twelve months, notwithstanding any change to the status quo. As such, potential remains for a re-focus on corporate reform to catalyse another bout of improved sentiment towards Japanese equities; we note that some of the market’s major shareholders, including Japan’s Government Pension Investment Fund, have recently sent signals that they will try to improve the governance of their investee companies in line with Abenomic’s targets.

Fig 3Figure 3: A greater percentage of Japanese companies have net cash positions than in any other major global equity market; however, they still have the lowest average dividend payout ratio. The Japanese government and a number of major shareholders are striving to implement reforms to change this situation, which would be of significant benefit to shareholder returns.
Source: Société Générale Group, 2017

Fig4Figure 4: Despite relatively poor corporate governance, Japanese equities pay similar dividend yields to their US peers. Governance reforms could raise yields, which would leave Japanese equities attractively valued at a time when the earnings backdrop is highly supportive. We note that although European yields are higher, they have lower growth potential as dividend payout ratios are already high and corporate financial positions more stretched.
Source: Société Générale Group, 2017

One factor that could significantly boost domestic demand, inflation and investor sentiment towards Japan is a large increase in fiscal spending. The Prime Minister has promised a significant increase in fiscal stimulus in the country and the government is due to announce a new long-term fiscal policy framework in June. Investors have speculated over the potential for the introduction of a ‘helicopter money’ policy in Japan for some time and we would expect such a development to be taken very positively by investors, likely catalysing increases in growth and inflation expectations (if such a policy was structured correctly). Nevertheless, the need for Japan’s highly-indebted government to maintain some element of fiscal discipline could cause its plans to disappoint yet again and we are reticent to read too much into such pledges in advance as they have led to disappointment in the past.

The move towards QQE means that the BoJ is no longer committed to buying a specific value of bonds in the market every month. However, by keeping yields relatively constant the BoJ has dramatically reduced the chance of making capital gains or losses in the Japanese government bond market (in local-currency terms). What the BoJ is still committed to is purchasing large values of exchange-traded Japanese equity funds. This policy has been cheered by existing equity investors, who are benefitting from the upward technical pressure these purchases put on Japanese stocks. However, it has also come under attack from others parties, such as pension funds, who see it as propping up market valuations and reducing the income new investors can generate from their capital.

The BoJ has already become a top-five shareholder in over a third of the Nikkei 225 Index’s underlying constituents and it is expected to become the largest shareholder in around a quarter by the end of the year. As such, the sustainability of its ETF-purchase programme is likely to come under increasing scrutiny as time progresses. Any change in its policy would be likely to have a significant effect on the performance of the market, more so given that it could dramatically affect sentiment among foreign investors, the other major marginal buyers of Japanese assets.

We note that the BoJ still retains some control over the shape of the Japanese government bond yield curve via its adjustment of the amount and duration of bonds it purchases. By steepening the curve, the BoJ has provided some support to the profitability of the country’s financial sector.

Conclusion

Overall, Japan’s economy is showing some green shoots, but longer-term cultural headwinds remain significant hurdles to momentum within the domestic economy. Likewise, the corporate backdrop looks very favourable, but without reforms investors are unlikely to feel the full benefit of any improvement in aggregate corporate performance. Nevertheless, policy remains highly supportive and the political stability Shinzō Abe has been able to bring to the country has improved the chance of much needed longer-term reforms succeeding in our view.

The Japanese equity market largely remains at the mercy of the global economic backdrop, with the strength of the yen not only a key driver of corporate profitability, but also of sentiment towards Japanese assets more generally. Given that we expect the yen’s strength to be determined by external factors over the next 12 months, we are unable to become more constructive on the prospects for Japanese equities until more momentum builds in its domestic economy, particularly as Japan has repeatedly failed to fulfil its potential in the past. Despite this, significant profit will be available to investors who can identify shareholder-friendly companies benefitting from the country’s favourable corporate environment.


This article was first published by Brookes MacDonald in 19th April 2017.