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Darius McDermott: It’s time to reconsider Japan

darius mcdermottDespite global headwinds, don’t ignore the country yet

Close to six years since coming to power, Japanese prime minister Shinzō Abe’s position is looking stable.

His recent victory in the Liberal Democratic Party leadership election provides him with another three years as leader of the ruling party and represents his third term. He has once again overcome a string of domestic scandals – and is on course to become Japan’s longest-serving prime minister.

For long-standing supporters of “Abenomics” (which refers to his economic policies since 2012), this victory will spell good news. The prime minister can make progress with his three “arrows”, which aim to break Japan’s 20-year deflationary cycle. The arrows are made up of quantitative easing, fiscal stimulus and structural reforms. So far, these appear to have gained some traction.

Japan’s gross domestic product grew at an annualised rate of 3 per cent over the three months to the end of June – representing its fastest pace since 2016.

The opportunities for investors from Japanese societal change

Unemployment stands at a 20-year low, driven by an increase in Japan’s labour force participation rate and changes to the tax system which have encouraged married women to return to work. This initiative formed part of Abe’s third arrow, which aims to improve corporate governance, raise salaries and get more people working.

Japanese companies across the market spectrum appear to be benefiting from the changes that have been put in place over the past six years – and this is demonstrated by substantial improvements to corporate profitability and earnings growth over this period.

Investors who have gained exposure to the Japanese market since Abe was first elected are likely to have made handsome gains. The Topix has risen by 132.1 per cent in sterling terms, according to FE.

Nevertheless, it has not all been plain sailing. Between February and November 2016, the market proved lacklustre on the back of a raft of disappointing economic data and a consumption tax hike.

Fortunately, things have picked up since then and Japanese equities have again performed strongly.

Looking ahead, is there likely to be another leg in the Japan rally?

I think the market has further to go for several reasons. Firstly, and most importantly, Japanese stocks still look cheap – particularly when comparing with their American and European counterparts.

After grappling with two decades of deflation, companies have accumulated significant cash piles. Over time, improved sentiment and corporate reforms should encourage these companies to return this cash to shareholders or to reinvest in the business – two factors which would prove positive for investors.

Political stability represents another advantage. The prime minister has been given the green light to progress with Abenomics, and I will be watching his third arrow – structural reforms – with particular interest.

Finding pockets of value in emerging markets

There will be opportunities for investors to make money in this market over the coming years; the key is to back an active manager with a proven track record.

Japan is a cyclical market, which means it can display a high correlation to global GDP.

The market swings between favouring growth and value fund managers, so it makes sense to hold a combination of funds with complementary styles.

For investors who are looking for a growth tilt, I would highlight the Baillie Gifford Japanese fund. Managed by Matthew Brett, it has been one of the most consistent in the sector and has outperformed in different market environments.

AXA Framlington Japan is another pick. Fund manager Chisako Hardie follows a growth at a reasonable price style. Although the manager has the flexibility to invest across the market cap spectrum, she has established an excellent track record in the small-cap space. As this part of the market is under-researched, you can pick up good value there.

Meanwhile, Schroder Tokyo is a solid core option. Its focus on quality stocks means that it is typically less vulnerable to swings in the market between value and growth. The fund also benefits from having an extremely experienced fund manager – Andrew Rose.

Investors who are thinking about increasing or initiating an allocation to Japanese equities must be aware of the potential headwinds. These include ageing demographics, a shrinking workforce and subdued inflation – which stood at 0.9 per cent in August.

While this continues to edge upwards, it is still some way off the Bank of Japan’s 2 per cent target.

Global trade represents another risk. As the trade war escalates between the US and China, Japan must be careful not to get caught in the crossfire.

As Japan is an export-led economy, a fall in global growth would spell bad news for the country.

Despite the headwinds, I don’t think investors can ignore Japan. Close to six years since coming to power, Abe has the potential to drive further positive change. What’s more, the market offers some value.

Nevertheless, investors must be prepared for bumps along the way. Investing in the Japanese market is never an easy ride.

Darius McDermott is managing director of FundCalibre

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