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Darius McDermott: Is the Japanese dream team out of ammunition?


To say Japan has had a tricky start to the year is an understatement. Negative interest rates introduced at the end of January bizarrely boosted the yen, while equities tumbled 14.7 per cent in the two weeks following the cut.

That is Japan in a nutshell really: investors can either be wildly successful or wildly unsuccessful. Politics, the central bank and the currency make or break returns, and the traditional wisdom of taking a long-term view has not necessarily proved profitable.

The stark truth of it is over the past 20 years UK investors would have been better off keeping their money in cash than the Japanese stockmarket.

Saying that, the case has been more promising recently. I have been bullish more or less since Japan’s prime minister Shinzo Abe returned to power at the end of 2012 and the market has recovered by more than 50 per cent from that point, despite this year’s performance.

Back then, there was a renewed sense of optimism in the land of the rising sun. Abe’s famed three arrows were just being nocked (for the archers among you) and if the world’s third-largest economy was poised for a comeback, people wanted to be part of it.

Three years on, results are mixed. Japan’s biggest danger is its debt and, try as they might, Abe and governor of the Bank of Japan Haruhiko Kuroda just cannot get the economy going in a way that will raise sufficient tax revenues to fund the budget and start to make a dent in those loans.

Deflation has not been vanquished as Abe enthusiasts might have hoped. And the extended period of low to non-existent price growth has done serious damage to the Japanese mentality. Someone who joined the workforce 20 years ago, like I did, has only just seen a small period of sustained inflation for the first time. It is no wonder employees remain reluctant to splurge and consumer spending is not contributing what it ought to the nation’s economy.

When the BoJ cut into negative territory, the last thing it wanted was to see its currency appreciate. Not only did it put corporate profits earned abroad under pressure, it also signaled to the world the Abe-Kuroda dream team might finally be out of ammunition.

Japan’s corporates have extensive exposure to international economies and many of its major companies are in cyclical industries. The fortunes of its own economy are heavily dependent on the world’s outlook. So, if you think China will not have a hard landing, the US is going to muddle through and the eurozone will manage to keep it together, you could still build a bull case for Japan.

On the other hand, one of the main unknowns everyone is talking about right now is “helicopter money”. Detailed definitions vary but this is basically another way of printing money to stimulate the economy – except the central bank will not ask for it back eventually. If it sounds too good to be true, it probably is. And who knows how markets will react? Will the BoJ go that far? It is hard to say but you cannot rule it out.

Another thing you really need to be cognisant of in Japan is the way currency hedging can affect returns. Rather than adding an extra layer of protection, it is more akin to going in with a “double or nothing” approach.

If the yen strengthens (as it has done) and equities fall, you lose out on the stockmarket and you do not get the slight buffer of converting back into sterling. But if the yen falls, your returns are hedged against the exchange rate impact and you get the full potential stockmarket upside (without currency losses).

So, depending on your view of the macro, there are different ways to play the Japanese equities sector. And while over the last 20 years investors might have been better off in cash than a passive market tracker, a few active funds have done pretty well. Plus, remember, we are not likely to see the likes of 5 per cent cash returns again any time soon.

One of the oldest funds in the sector, Baillie Gifford Japanese, for example, has returned 180 per cent versus the Nikkei 225’s loss of 18 per cent (in sterling) in the past two decades. It is a solid growth fund, managed by a team that researches sectors across the market and generates fresh ideas.

Another couple of funds I like – although they have not been around quite as long – are Schroder Tokyo and Neptune Japan Opportunities. As a fund that currently has a currency hedge (and has had for some years) the Neptune one has had a particularly rough start to 2016; however, since its launch in 2002 it has more than doubled the Nikkei’s returns.

The Schroders fund, meanwhile, benefits from an 18-strong team on the ground in Tokyo and an excellent track record. It has all the right ingredients for a core Japan holding.

Darius McDermott is managing director at FundCalibre



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