There has been a quiet outperformance of Japan equities, making the country a relatively high conviction overweight, writes Robert Samson, head of Global Multi-Asset at Nikko Asset Management.
Momentum is picking up, and not from where most would have expected in early 2023 – tech and Japan, a seemingly odd pair at first blush. Over the last several months, we have discussed the re-emergence of tech and AI as a new secular growth theme, but perhaps less known is the quiet outperformance of Japan equities over most global peers. We have long found Japan to be an appealing market for its attractive valuations and defensive characteristics – particularly over 2023, but historically the market has largely fallen short of generating significant growth opportunities.
Has something changed? Perhaps, and the story may be even stronger than “Abenomics” back in 2013 in the form of three arrows that ultimately failed to deliver Japan from its deflationary trap in place since the burst of the Japan equity market which peaked back in 1989. Reforms are ultimately the remedy, but policy initiatives were seemingly incapable of dislodging the deflationary mindset until now when actual inflation has changed the mindset rather quickly.
Inflation is ordinarily viewed as negative for an economy, but it just may be better than the deflationary alternative. Real inflation has created a sense of urgency that reforms actually need to be firmly executed as former business practices (sitting on unproductive capital) simply do not work in an inflationary world. Japan is pushing reforms, and business leaders are taking them very seriously not just to abide the directive but rather for survival.
Japan recovery: more than just hope
Reforms succeed when well executed, but the devil is in the details and more importantly the psyche of all the stakeholders. Poor governance has been a headwind for Japan equities over decades; among them is “keiretsu”, when companies own each other’s shares without serious demands for any return on capital.
This is changing with the Tokyo Stock Exchange (TSE) seriously ramping up reforms to require companies to build shareholder value, measured by companies’ price-to-book ratio (PBR), where many fall below the “1″ threshold, typically viewed as destroying capital, not creating it.
In a deflationary world, a gradual decline in the capital base might be tolerated as a store of (decreasing) value, but not in an inflationary environment where growth is a necessary hedge. Add to this wage pressures, and companies have no choice but to re-think their business strategy. Buybacks are increasing, and more companies are setting specific targets to increase shareholder value.
These are early days, but it is nevertheless a notable and necessary shift in corporate behaviour. Shares have significantly re-rated, but are they yet expensive? Compared to its own history, Japan equities do look slightly rich. But compared to other markets around the world, it is still reasonable: 17x forward price-to-earnings versus 19x for the S&P 500 index. In terms of PBR, the largest 100 companies in the Nikkei trade at a massive discount to S&P peers.
Of course, much of this discount is justified as Japan companies collectively have done a very poor job delivering return on capital. However, as nearly a quarter of the largest 100 Nikkei companies still have a PBR below the TSE “1” stated lower bound (one-seventh of the lowest PBR in the S&P 100), the bar for improvement is quite low and companies should be highly motivated, first to keep their listing and second to remain competitive.
Such reforms are also supporting renewed interest for direct investment in Japan—from semiconductor production to a broad range of products and services to gain access to Asian growth which is increasingly viewed as a safer alternative to investing in China, which remains under the weight of high (and rising) geopolitical tensions. Many in the West are also deeming Taiwan as a riskier investment proposition, though we do not view an invasion as a near-term risk for the island.
Real fundamental change will take time, but the risk does look skewed to the upside for now. Japan is still very externally exposed to a US recession, which could dampen the mood quite quickly if such a recession were deeper than our shallow base case.
Still, valuations are attractive, earnings are improving and the spreading sense of conviction that reforms are not just “good” but also very necessary for a sustainable future makes Japan a relatively high conviction overweight.
