The case for Japanese equities

In the calendar year to date, in common currency terms Japan’s equities have outperformed global markets by  a modest 1%, but at some point investors may reasonably become more positive on Japanese equities. Judging from 24 years of experience, any such call has to be tactical unless proven otherwise, and Japan faces significant challenges with structural weakness: nominal GDP is back to 1991 levels, the BoJ balance sheet is unchanged from January 2006 levels, the RoIC is nearly a third of US levels, and the improvement in corporate governance has promised much but appears to have delivered little (RoE targets for some companies became Return on Enterprise Value as opposed to Return on Equity).

The stale bull case for Japan is centred on apparently cheap valuation on book or replacement value, the private sector is underleveraged, margins in Japan are (very) low in absolute terms, housing is cheap (on OECD data) and into a tail-risk scenario in either direction (much stronger growth or a sharp rise in VIX), Japan typically outperforms in dollar terms. Now there are potential new positives.

It is also the only major economy to have much faster growth in 2012 than 2011. Based on historic relationships between bond yields, the JPY/USD, lead indicators and foreign buying, Japan has around 12% further upside potential relative to global markets; relative earnings momentum has turned positive; when Japan outperforms it normally does so by a large amount; relative risk appetite in Japan (versus global markets) is still below previous peaks. On the whole many investors appear to have given up on Japan strategically; the stage of the cycle is mildly supportive, with Japan in particular likely to be the best performing market when US bond yields rise;

Apparently cheap valuation has been a bull argument for an extended period and this is particularly the case when considering balance sheet measures. Thus 70% of Japan’s companies trade below replacement value, while cash on the balance sheet is 26% of market cap. Furthermore, Japan’s equities are at the bottom end of their historic range on price/earnings and price/book. But Japan’s equities have traded cheap for a reason and the major issue for Japan is whether it will capitalise on its significant restructuring potential. From a macro perspective, productivity per capita is lower only in Portugal and Greece (Japan is particularly unproductive in the domestic service sector industries, which have been protected by regulation). Meanwhile its profit share of GDP is nearly half that of the US yet its investment share of GDP is nearly double that of US. Given that the investment share has historically been high, this means that the return on invested capital is extremely low: indeed it is a third of US levels. The macro manifestation of this is over-employment. Japanese unemployment is at 4.6% compared to 8.3% in the US. The number of employed people in Japan is 2% lower than early 2008 levels (pre Lehman’s crisis), while GDP is down 4%. In the US GDP is now above previous peak levels, but employment is around 4% lower (around 5m jobs).

There are signs of a more pro-shareholder climate: cross holdings have fallen from 50% to 12% of market cap, equity is now used more frequently as a financing vehicle, foreign shareholders now own 27% of the market (vs a low of 3% in 1989) and thus have more influence and Japan’s demographics suggest that pension schemes should increasingly demand yield. Yet, a fundamental problem for Japan is that it lacks the ‘stick and carrot’ of Western corporate governance. There is little aggressive M&A or private equity to force out underperforming managements. Share options schemes tend to be limited and equity does not have the same role in financing as in other major markets. Japan’s poor restructuring record also reflects a culture where sales have been seen as more important than profits. Also the household sector is a net creditor and thus there is limited pain into deflation and Japan has very difficult demographics, with the working age population due to shrink by a third by 2050. This leaves Japan as at best a 1% GDP growth economy. Meanwhile, inflation expectations in Japan are now the highest they have been since September 2008 but we may now be at the point where a rise in inflation expectations is accompanied by a re-rating equities relative to bonds. In the US, equities re-rate until inflation rises to 2%, but then de-rate once inflation rises above 4%.

his suggests that there is a required focus on the policy agendas of Japan’s government and central bank, as well as its companies and the risks of renewed disappointment

Japanese equities and the policy agenda

With Japan’s trade balance and current account balance having slipped into deficit, the Japanese government have become more reliant on foreign funding, and face increasing the risk of upward pressures on 10 year Japanese government bond (JGB) yields.

This suggests that Japan’s government and central bank may take more action than hitherto, and it looks as if at some point, Japan will need to tighten fiscal policy by 9% of GDP to stabilise the government debt to GDP ratio.

For now, IMF data suggest that Japan is the only major developed market economy enjoying fiscal easing, thanks to the government’s reconstruction spending in the Tohoku area which has only just started. The government has earmarked ¥19tn, or around 5% of GDP for the works. The IMF estimate that the cyclically-adjusted budget deficit in Japan will be 8.6% of GDP this year, up from 8% in 2011. Japan will likely see fiscal easing equivalent to 0.6% of GDP this year.

This is happening at the same time as monetary easing and the Bank of Japan (BoJ) may be more aggressive than the market expects, as a consequence of rising political pressure from the DPJ. More than 100 members of the DPJ seem to be in favour of limiting the BoJ’s independence, and there looks to be a good chance that proposals amending the BoJ rule book will be presented to the Diet by the end of current session (late-June).

The first of two key proposed amendments is that it should be the responsibility of the BoJ and the government (as opposed to just the BoJ) jointly to come up with an inflation target. This is important because some politicians are calling for an inflation goal of 2% against the BoJ’s current stated inflation ‘goal’ of 1% over the medium term, and against an inflation forecast of ½% for FY 2013.

If it is to achieve this goal of increased inflation, the BoJ needs to create more monetary stimulus, and historically the BoJ seems to have accepted deflation and put the Japanese economic plight down to structural reasons (such as demographics and the need for de-regulation), as opposed to monetary policy.

The second amendment is a proposal to have explicit governmental influence over the nomination of BoJ board members. Currently the BoJ picks its own favourite candidates for six non-titled board members.

Even if there is no change in legislation, the BoJ governor’s term ends in early-April 2013 and two deputy governors are due to finish their tenure in late-March 2013, so change is afoot.

Meanwhile the BoJ has committed to increase its Asset Purchase Programme (APP) by ¥10tn to ¥65tn. Current purchases stand at ¥46tn, implying an additional ¥19tn of purchases, mostly to finance JGB purchases, for the rest of the year. In addition ¥1.8tn of liquidity is being provided through the conventional JGB buying programme (the so called Rinban) every month. Therefore liquidity provision by the BoJ toward the year-end could amount to around ¥35trn or 7.5% of GDP. Even discounting modest sterilisation, the BoJ’s balance sheet would increase by 6-7% of GDP (from 31% of GDP currently) by the year-end without any further policy changes. In addition, since November 2010, the Bank of Japan has shown willingness to engage in unorthodox measures through its purchases of ETFs and J-REITs as well as continued purchases of corporate bonds.

In determining the way forward for the Japanese economy we will need to keep a close eye on the substance of actions by the government and BoJ. We can’t hold our breath as decades of disappointment caution against too much enthusiasm – but equally we must be alive to the possibility that change for the better is on the way.

Japanese equities: the risks

Whilst there are grounds for cautious optimism on the prospects for Japanese equities, Japan faces significant headwinds. With a primary budget deficit of 9% of GDP, net government debt to GDP of around 120% on OECD data and a 10-year real bond yield of 1%, it looks as if the required fiscal tightening to stabilise government debt is likely to be around 9% of GDP (compared to 8% in the US and 6% in the UK). Furthermore, Japan’s visible trade balance and current account balance have just slipped into a deficit. While some of the drivers of this move are temporary, Japan may well have a structural current account deficit going forward

As a consequence of the external deficit, the share of the Japanese government debt market held by foreigners has started to increase, from 6% in 2010 to 8% currently. There is a risk is that the Japanese government bond market will be more reliant on foreign investors, and thus more vulnerable to rises in bond yields (as foreign investors are generally more likely to sell if there are concerns about the viability of the bond market, and less likely to be satisfied with the low rates that have prevailed over the past decades).

The risk of higher bond yields is particularly worrying because the IMF reckon that the government’s total financing needs for this year (bond maturities plus the deficit) are equivalent to 60% of GDP, compared with 30% in the US and around 15% in the UK. The cost increase of raising these funds for every 1% increase in bond yields, at 1.2% of GDP, is considerably higher than for any other major developed market.

There are also well known demographic challenges: on UN estimates the working age population is set to shrink by around 30% over the next 30 years (from around 80m in 2010 to around 60m in 2040), leaving fewer tax payers to service the considerable government debt. The government’s decision to raise the pension eligibility age gradually from 60 to 65 years by 2025 seems inadequate to address the challenge (in particular, given that there seems to be no intention to loosen immigration policy).

That said, with government revenue at 33% of GDP (compared to an OECD average of 38%), it is politically feasible to tighten and a small rise in JGB yields (c1½%) is probably positive, although thereafter it would likely become a problem.

There is then Japan’s heightened dependency on oil after the earthquake, compounded by the challenge that if macro momentum rolls over sharply, then Japan will likely underperform (in fact, the relative performance tends to peak one month after the peak in the US ISM new orders). Unfortunately, the evidence that this is happening have increased: the US macro surprise indicator, which tends to correlate well with US economic momentum, has started to roll over. Furthermore, the regional PMIs in the US also point to a weakening in momentum.

One problem historically has been that Japan’s household sector is a net creditor and thus benefits from a deflationary bias in the economy. Consequently, there tends to be a poor follow-through on reflationary policies. Furthermore, in general, lifetime employment has historically been seen to be more important than RoE in Japan. Against this backcloth, competition from China and the rest of Asia is a key concern. 18% of Japanese exports go to China – and clearly China has been taking market share from Japan (on the back of a lower cost of capital, excess investment, an undervalued REER and a zero cost of carbon). It is interesting to note, though, that the Asian export exposure of Japan seems to have peaked.

Japanese equities are risky – but the problems are well known. The challenge is determining when a re-weighting to the region may be sensible for investors considering equity risk.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla