Last week, Japanese Prime Minister Shinzo Abe called a snap election trying to capitalise on increased public support over the summer, as the North Korea issues intensified. If the election result was to grant him a larger majority, it will enable him more room to proceed with his economic plan. However, with the June UK election experience still fresh in our minds, this could feel like a dangerous gamble.
Given the “lost decades” of returns experienced by the Japanese equity market (see figure 1) investors might feel that the opportunity cost of avoiding such exposure, especially amid increased political uncertainty, would be minimal.
But today, the Japanese equity market looks significantly different from a valuation perspective to what it used to. An earnings yield at 7% (compared to less than 2% in 1994) offers attractive potential returns both on an absolute basis and relatively to MSCI World, while the equity risk premia remains one of the most attractive in the market.
In the summer, Johan du Preez at M&G’s equities forum discussed how we should not let past experiences colour our judgement of the Japanese market today. So, with compelling valuations on our side, let’s step away from the political noise and address some of the key macroeconomic issues.
The Economic Backdrop
Public sector debt remains high, but as already described by Eric Lonergan in a previous blog, the Bank of Japan owns a large part of the outstanding government debt (around 40%) suggesting that this problem is frequently overstated.
At the same time, GDP growth has been stabilising at around the 1.4% YoY, with consumption and investment growth in particular contributing positively in the last few quarters. Household consumer confidence has been improving, while retail sales have seen positive growth YoY for the last 11 months in a row. Japan has also been enjoying a strong and steady decline in its unemployment rate since 2009 to a mere 2.8% as of last July, together with an increase in labour force participation rate (mainly driven by an increase in female labour force participation).
Most importantly from an equity perspective, corporate earnings have continued to improve, so much so that latest delivered earnings per share numbers were above where analysts expected them to be twelve months ago.
Business sentiment as for the Tankan business conditions survey (current and forecast) also point towards positive and improving conditions for corporates to operate in.
Improving corporate governance could also play an interesting role in unlocking further value going forward. With the publication in February 2014 of “Japan’s Stewardship Code” by the Minister for Financial Services, the government defined new standards for institutional investor responsibility.
The objective is for institutional investors (both asset managers-directly and asset owners-indirectly) to engage with the companies they invest in in order to foster sustainable growth over the long term. Over time, this is likely to improve ESG standards at company level and in particular to reduce the use of complicated cross-holding structures that still characterise several Japanese companies.
Although the success of “Abenomics” might be debatable, Japan’s economy seems to be on the right track and the overall macroeconomic picture points towards a benign environment for Japanese corporates going forward. This, combined with attractive valuations, makes Japanese equities an interesting investment over the medium term. The political landscape might be getting more complicated and potentially bring some uncertainty to the market, but this could in turn provide additional opportunities.