World Investment Outlook - Chapter three: Japan

With the Nikkei 225 and Topix stock benchmarks touching twenty-year peaks, the yen rising against the dollar and the economy putting together its best streak of quarterly GDP increases for a decade investors could be forgiven that everything in the Japanese garden is rosy.

The Nikkei 225 ended 2017 with a powerful run, aided and abetted by Prime Minister Shinzō Abe’s latest General Election victory. For the PM, the dream of leading his country when the 2020 Summer Olympic Games begin remains very much alive as a result and if he can steer clear of trouble for that long then Mr Abe would also earn the distinction of becoming his country’s longest-serving leader ever.

The Prime Minister’s campaign may have been helped by North Korea’s decision to fire test missiles over Japanese waters, even as he continues to press for changes to Japan’s avowedly pacifist constitution. His move to call a snap election for October also broke apart the opposition Democratic Party of Japan and smothered the would-be upstart Party of Hope.

Corporate performance has been good – even if Toshiba’s financial worries and scandals over data falsification at Kobe Steel, Mitsubishi Materials and other started to hog the headlines – and the Tokyo stock market is hardly expensive on earnings or book value metrics, even if its yield is unlikely to tempt income-seekers. But sceptics will point to the influence of the Bank of Japan’s (BoJ) colossal Quantitative Easing scheme, which leaves the central bank as a key influence on stock as well as bond prices.

Even if Governor Haruhiko Kuroda is running monetary policy at full tilt right now, investors will want to know what may happen if and when he ever decides to curtail monetary stimulus, or follow the US Federal Reserve’s path and contemplate withdrawing it.

Economics

In the third quarter of 2017, Japan racked up its seventh straight period of growth, its longest run for a decade, and its best sequential rate of improvement for over two years.

Japanese GDP growth under Prime Minister Shinzô Abe

Source: Thomson Reuters Datastream

Whether this is down to the ‘Three Arrows’ of the ‘Abenomics’ reform programme, the Bank of Japan’s negative interest rate (NIRP) and Quantitative Easing (QE) policies, 2017’s fiscal stimulus programme, improved exports or a combination of all four is hard to divine. At least the results are tangible and they will be welcomed by both Prime Minister Abe and Bank of Japan Governor Haruhiko Kuroda alike.

However, it would be wrong to say that Japan is finally emerging from the woods in which it found itself so thoroughly lost when the equity and property bubble popped so spectacularly in the early 1990s.

• Every previous attempt to wean the economy off fiscal or monetary stimulus (or both) or hike interest rates has quickly come to grief and led to some serious backtracking by the authorities.
• Inflation is still woefully below the Bank of Japan’s 2% target, a threshold which has only briefly been crossed during the ‘Abenomics’ years.
• Wage growth also remains muted, even though unemployment stands at a two-decade low of 2.8% and the job-offers-to-applicant ratio stands at a 33-year high of 1.52. Total wages actually fell 0.3% year-on-year at the last count. This leaves Abe and Kuroda with the same conundrum which is foxing and frustrating Theresa May and Mark Carney in the UK and Donald Trump and Janet Yellen in the USA – the Phillips Curve seems to be broken, in that low unemployment is not sparking wage (and broader) inflation.
• Hampered by weak growth and modest wage inflation, poor demographics and burdened by over two decades of (relatively unsuccessful) fiscal and monetary stimulus programmes, Japan’s sovereign finances are in a shocking state. Government debts come to around 240% of GDP, according to the CIA World Factbook. This is the highest such figure in the world and it leaves Japan in the less-than-exalted company of such economic problem children as Greece, Jamaica, the Lebanon and Italy.
  

Japan is still labouring under crushing sovereign debts

Source: CIA World Factbook, 2016

Japan is struggling to grow or spend its way out of its debts so a further option is to raise taxes, although this is not palatable prospect. An increase in consumption tax (the Japanese equivalent of VAT) in mid-2015 from 5% to 8%, sanctioned by Abe’s predecessor as Prime Minister, the DPJ’s Yoshihiko Noda, punctured the economy. Abe took the hint and pushed back the planned increase to 10% out to 2019, although members of his LDP party are already fretting about this.

The International Monetary Fund (IMF) is also arguing that Japan should not withdraw fiscal stimulus in 2018 and even contemplate further fiscal stimulus should the consumption tax hike go ahead as planned in 2019. Its forecast of 0.7% growth for 2018 offers
Abe and Kuroda scant encouragement although they may be more pleased to see the brewer Asahi push through a first price increase for its beer in a decade during the autumn. Perhaps inflation is not so far away after all.

Markets

Japan appears to be politically stable and showing relatively robust economic growth. Investors also seem confident that this can last, even the Bank of Japan ever gets round to pausing its Quantitative Easing (QE) scheme or even withdrawing it.

Encouraged by Prime Minister Abe’s latest election triumph, Japanese stocks put on an end-of-year spurt that took them to third in the international rankings for 2017, when measured in total return, sterling terms.

Japan has performed well in 2017, helped by a year-end rally

Source: Thomson Reuters Datastream, based on Nikkei 225 index. Total returns in sterling terms, 1 January to 30 November 2017.

That comes after a sixth place in 2016, although contrarians may feel this means there is an opportunity to be had if Japanese GDP maintains its current momentum and the Abenomics reform programme continues to persuade Japanese companies to be more shareholder aware and focus on improved profits, return on equity and cash returns to investors.

Currency conundrum

One complicating factor remains the yen. In principle the Bank of Japan is far from concerned about defending its value, given its desire to electronically create ¥80 trillion yen a year out of thin air to fund its QE scheme, and this is understandable, as a weak currency could in theory help exports and give the wider economy a boost.

Investors who are seeking exposure to Japan may therefore need to think about the currency or – if they prefer – buy an active or passive fund which comes with a currency hedge, albeit potentially in exchange for a higher-than-average annual fee, relative to an unhedged collective.

The yen confounded the doubters by holding its own in 2017

Source: Thomson Reuters Datastream

A further consideration is the Bank of Japan’s influence on the Japanese equity market.

As part of its QE plan, the Bank of Japan is not just buying bonds. It is buying exchange-traded funds (ETFs) too. Sceptics will therefore want to know why anyone should buy a market ....

• where the central bank was the single largest buyer of stocks in 2016
• where it owns three-quarters of the total assets in Japanese ETFs (according to research from Société Générale)
• and where the central bank is a top-ten shareholder across 90% of the stock market (according to Bloomberg)

What happens when the Bank of Japan stops QE and stops buying? Or tries to unwind it and starts selling?

At least a forward price/earnings (PE) multiple of around 14 times and price-to-book (or net asset value) multiple of 1.3 times, based on analysis from Société Générale, suggest there is may be some select value to be had, especially if Abenomics helps to drag the country out of the debt mire and corporate performance improves.

One indicator which investors can use to see if better times lie ahead for both the economy and the stock market is the Tankan.

The Short-Term Economic Survey of Enterprises in Japan, to give the report its full name, comes out right at the start of every calendar quarter, as the BoJ assesses corporate sentiment across 10,000 companies.

The September survey, released in early October, was strong. The scores for both large manufacturers and small and medium-sized firms reached ten-year highs, while the number of firms citing labour shortages reached a level not seen since 1992. The overall business conditions reading for all firms rose from 12 to 15.

The Tankan corporate sentiment survey’s recent strength could bode well for the Nikkei index

Source: Thomson Reuters Datastream

Even if the past cannot offer any guarantees for the future, the Nikkei 225 seems to correlate with the Tankan, so any upturn in corporate confidence could mean that huge pile of cash will start to finally circulate, potentially benefitting the economy and stocks alike. A fresh outbreak of caution would be a less welcome sign.

Russ Mould, AJ Bell Investment Director

Next chapter

Read more from our World Investment Outlook 2018 series:

World Investment Outlook - Chapter one: UK

World Investment Outlook - Chapter two: USA

World Investment Outlook - Chapter three: Japan

World Investment Outlook - Chapter four: Asia

World Investment Outlook - Chapter five: Western Europe

World Investment Outlook - Chapter six: Emerging Markets