Japanese equities have been testing investors’ patience lately, although their lacklustre performance stretches back 12 months.
Having anticipated the Japanese renaissance when Shinzo Abe was elected prime minister in December 2012 (a move that saw the Topix index rise from its torpor around 500 to over 1100 last summer, before falling back to around 800), we have had to ask ourselves if our overweight position is still valid. Perhaps it is not different this time, after all?
Until Abe’s recent success in the upper house elections, in which he won a renewed mandate for his programme of reforms, global investors appeared increasingly unconvinced by Japan’s grip on its own economy. The stockmarket only seems to respond positively to sentiment about Chinese, and therefore global, economic growth and yen weakness, which is discouraging when compared with the fundamental value we originally identified.
Japan’s macroeconomic recovery has floundered and many investors have lost faith in Abenomics, although first-quarter GDP growth rebounded from a contraction in the final three months of 2015 (see chart).
And, while it did not suggest a contraction, the Bank of Japan’s latest quarterly business confidence poll, the Tankan, was disappointing: firms’ inflation expectations have weakened, wage growth is lacklustre and leverage is not accelerating.
“Funds that favour better-quality growth stocks have outperformed Topix and other international indices”
That said, we continue to see value in Japanese equities, largely driven by microeconomic factors. Four key secular drivers of outperformance are still intact:
- A radical improvement in return on equity as a result of the revolution in corporate governance
- Increasing shareholder focus that should lead to the return of a cash mountain by way of dividends and share buybacks.
- Huge potential for multiple re-ratings as pension funds (and now the BoJ) allocate to equities
- Huge potential for multiple re-ratings as positive inflation expectations and the hunt for yield lead households into equity ownership.
While share prices have struggled this year, operating margins have held up well and share buyback announcements totalled ¥4trn by the end of May. To put that in context, total buybacks for the whole of 2015 amounted to ¥5trn.
Goldman Sachs estimates that Japan’s four major public pension funds are underweight by ¥9trn compared with its new government-directed target for domestic equity exposure.
Meanwhile, the BoJ has approved its macroeconomic stimulus package, which will be a bonus.
We remain committed to Japanese equities but acknowledge they are unfashionable right now with many global investors.
To mitigate this, we prefer exposure to growth rather than value (the “weak yen, export-driven” behemoths). Funds that have favoured better-quality, higher-growth stocks with a commitment to corporate governance, rather than simply buying large-cap index exposure, have performed much better than the Topix and other international indices.
In time, the prevailing wisdom that equity gains require yen falls may also be challenged. First, there have been prolonged periods in which corporate profits had a positive correlation with the exchange rate. Second, of the four major Topix rallies since 1990, only one was accompanied by significant yen depreciation (1995-96). The S&P 500 also has a strong negative correlation with the yen and the exchange rate cannot logically benefit both.
Given its recent strength against sterling, we believe the yen will resume a downward trajectory against the pound now the UK has voted to leave the EU. That said, if additional purchases of Japanese equity ETFs by the BoJ spur overseas investors, this would strengthen the yen and we could enter a period of both positive equity and currency performance. As we have discussed, this situation is not nearly as unusual as recent history might imply.
We remain invested in Michinori Japan Equity, Baillie Gifford Shin Nippon, Coupland Cardiff Japan Income & Growth Trust, Coupland Cardiff Japan Alpha and JP Morgan Japan and JP Morgan Japanese investment trust.
David Coombs is manager of the Rathbone Multi Asset Portfolios