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Back to the future

Andrew Yeadon: Multi-manager View

Back in the late 1980s, the Japanese equity market was the place to have your money. Business writers eulogised Japan’s efficient “leanproduction” techniques while Japanese firms expanded their global influence. All this excitement led to a asset bubble that burst spectacularly, and for the last 20 years Japan has been working through a prolonged period of recession. Poor political leadership, an aging population that saved a lot and spent little and an uncompetitive exchange rate have all added to the economic woes.

After years of disappointment, many international investors have thrown in the towel, heavily underweighting Japan or not bothering at all.

Sceptics highlight the weakness of the economy, deflation and high Government debt as good reasons to avoid the region. These are legitimate worries. After years of trying to boost the economy through fiscal stimulus, the gross Japanese Government debt to GDP ratio has now risen to about 200 per cent, although the more realistic number is closer to 100 per cent once saleable government-owned assets are taken into account. This is almost on a par with Greece, except the Japanese government can fund its deficits by falling back on domestic savings rather than having to open itself up to the more critical scrutiny of international bond investors.

Japan is arguably the world’s cheapest major equity market. On a price-to-book value basis, it is lower rated than other markets and almost as cheap as it has ever been relative to its own history. On a price-to-trend earnings’ basis, it is as cheap as it has ever been when compared with the same measure for the rest of the world.Some might argue Japan is a classic value trap but others, including ourselves, are seeing an opportunity.

In early December, we moved over-weight Japan, partly on the valuation argument but also sensing it is reaching an inflection point. There is a new Government with a mandate for change, and while some are sceptical of the Democratic party’s ability to reverse decline, addressing deflation is now at the very top of the economic agenda. The yen should start to weaken from current overvalued levels, in part because demographic trends are leading to a falling savings ratio but also because of the likelihood of further quantitative easing and low interest rates.

While other big economies will become increasingly dominated by talk of exit strategies, there is little chance of any monetary tightening in Japan for the foreseeable future, which should, in time, start to undermine the yen. A weakening yen ought to help the relative competitiveness of the exporters – although it has also persuaded us we should hedge our yen exposure.

Japan’s geographical position allows it to benefit from growing exports to its rapidly expanding Asian neighbours. Add to that the fact corporate earnings are set to bounce strongly in 2010 and there is a growing case for having some exposure to Japanese equities. Japan has a habit of delivering periods of stunning returns off the kind of very low valuation base on which it currently stands. We are starting to sense the sun could rise on Japan again and conclude that Japanese equities are at least worth a modest bet.

Andrew Yeadon is head of multi-manager at Schroders

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