In equity market terms, perennial underachiever Japan has had more than it fair share of false dawns over the years.
Key to this has been locked-in deflation for more than a decade, but last year’s election victory by the Liberal Democratic Party (LDP) looks to have ushered in major political change – and with it, potential for the cheap Japanese market to rally. In the last four months, the market is already up more than 30% in yen terms and the currency has deteriorated around 20%. Among those enthused by the country’s prospects is Jupiter Japan Income manager Simon Somerville, who sees the LDP’s policies as fundamentally market friendly. “Companies are excited at the prospect of the Abe administration and its impact on the domestic economy,” he says. “Businesses have operated in a political vacuum in Japan, especially in the last six years or so when as many prime ministers went through a revolving door and were unable to implement effective policies. We now see excitement at the opportunity for change and the mandate prime minister Shinzo Abe has taken on – there appears to be a genuine belief that this time it is different.” Central to this is the inflation target, a key part of Abe’s election campaign. “We have talked about the importance of inflation for several years – and to have a bullish outlook on Japanese equities, there has to be inflation,” says Somerville. “Japan’s persistent deflation has created a difficult environment for people running businesses, struggling with constant price pressure for example, and inflation is helpful for healthier corporate earnings. “A further point is about asset allocation: rampant deflation has meant high real interest rates, which has led Japanese institutional investors into bonds rather than equities. Some inflation in the system would bring these high real rates down and increase the attraction of equities.” While there has been talk about inflation targeting in the past, Somerville says the fact it is now politically led – and by the fairly conservative LDP – shows how far things have changed.
“The one group of people who benefit from deflation is the elderly – typical LDP supporters – but the party has moved away from its traditional hunting ground in a bid to kickstart the economy,” he adds. “There is no magic switch to turn inflation on but politicians are taking steps and there are encouraging signs. Key to getting inflation is changing expectations – if businesses anticipate deflation, that affects how they do things from pricing goods to negotiating wages; if they expect inflation, this behaviour changes.” Elsewhere, the Bank of Japan has also been reluctant to act aggressively on inflation so far but with the LDP winning such a strong majority, central bankers are broadly expected to fall in line. Abe has already pressured Shirakawa, the current governor of the Bank of Japan, to accept a 2% inflation target and nominated Haruhiko Kuroda as the next governor of the central bank. Kuroda has been a consistent critic of Shirakawa’s policies and is known to be determined to overcome deflation While the LDP pledge was specifically about inflation targeting, economists highlight currency weakening should be an extremely welcome corollary. Somerville says the long-term currency appreciation that has hampered Japan’s exporters is once again linked to high real interest rates and inflation should help towards much-needed yen depreciation.
“If we get some inflation, equities are the major beneficiaries as a more appropriate asset class to hedge against rising prices,” he adds. “Many have questioned whether yen weakening is realistic as the currency is around fair value on a purchasing power parity basis but you have to remember Japan has been in deflation for 20 years. Weakening is realistic as long as we get inflation to bring down real interest rates, making the currency less attractive to domestic and overseas investors.” Jupiter is not expecting to get to 120 to the dollar as Japan is still importing fossil fuels but Somerville says the recent lows in the 90-100 range should take pressure off exporters. Beyond inflation targeting, Abe has also pledged to re-target government spending, implementing a massive ¥10 trillion fiscal stimulus and progressive tax reform. Somerville says this, together with inflation target, could at last see Japanese consumers spend some of their massive savings. Finally, Abe’s third objective is to implement a new long-term growth strategy for the Japanese economy, due to be revealed in June, ahead of the July Upper House election. While a focus on dividends is becoming increasingly popular globally, Somerville’s Japan Income fund – launched back in 2005 – remains something of a rarity in its sector. That said, Somerville is not a yield chaser and does not screen by dividend, preferring to focus on companies with healthy cashflow where management are comfortable with the Western concept that shareholders own a business. This often leads to a progressive dividend policy and Somerville says payout have increased every year for the last decade. “This is different from ten years ago when cross-shareholding was rife and there was little pressure to pay higher dividends,” he adds. “A dividend culture is growing in Japan but it is not across the whole market and one of our jobs as a fund manager is to identify companies that have embraced this method of rewarding shareholders.” Somerville is also prepared to pay up for growth to some extent, often looking past a company’s current P/E ratio to identify its prospects later in the cycle.
He gives the example of LIXIL, Japan’s largest housing materials manufacturer, which has grown through acquisitions with little regard for integration. “With some brands competing with one another and overstaffing, the business has grown its top line much more than its bottom line,” adds the manager. “New management has come in and basically smashed the businesses together but this restructuring is expensive, particularly making people redundant. LIXIL trades on 40 times this years earnings but this figure is misleading as it still includes the restructuring costs. By looking beyond current P/E, we can see good growth coming through and believe a P/E of 13 times is more accurate.” In recent years, several funds investing in the region have avoided so-called old Japan and focused on new Japan – alongside much of the emerging world, this has meant a skew towards domestic demand stories and away from exporters. While Somerville has been in this camp, recent trends in inflation and currency have caused a rethink. “We have had a strong focus on domestic demand names for the last five years and still see this an interesting part of the market, with many Western-educated Japanese bringing a fresh outlook to running companies,” he says. “However, with the current political and economic change bringing inflation and a weaker yen, exporters will clearly benefit, as will financials. This does not mean all of old Japan is attractive however and we continue to avoid companies that have yet to restructure and still have oversized workforces, which broadly means consumer electronics.” While a weaker currency has helped their share prices short term, he still believes fundamentals remain weak.
On the financial side, favoured stocks include Sumitomo Mitsui Financial and insurer Tokio Marine while consumer names include Canon, Nissan, Toyota and auto parts supplier Denso. Somerville highlights Canon as encapsulating the improved backdrop for exporters, with the company suffering in 2012 for various reasons. “As a classic exporting old Japan name with much of its production done locally, the company has struggled with yen strength as an ongoing hurdle,” he adds. “Canon also does a lot of business in Europe, largely companies using its copiers and printers, and has therefore suffered from the ongoing downturn on the continent. Despite all this, the company has still been generating good cashflows and has produced strong earnings and dividend growth. “As the macro issues are abating to some extent – with a weaker yen and Europe no longer deteriorating – we see an attractive opportunity.” Elsewhere, the fund has a fairly small position in healthcare despite Japan’s worsening dependency ratio, as these stocks are defensive and do not fit with current thinking. “Japan’s worsening dependency ratio is a clear theme and we have invested in areas such as nursing homes to benefit,” adds Somerville. “But valuations tend to be fairly high as this demographic situation is not a secret and companies plugged into these areas tend to command a premium.” As befits a look at Japan, it is worth ending by considering what factors might derail yet another surge in the stock market. With so much focus on inflation and currency weakening, Abe obviously needs to follow through on his plans but Somerville also flags up a worsening relationship with China as a major risk to Japanese equities having a strong 2013/14. “China is extremely important for Japan and could make things very difficult but we see the relationship as fairly symbiotic so any serious deterioration in unlikely,” he adds. “The Senkaku situation last year was a flashpoint and hurt Japanese companies like Sony and Canon but we feel it was largely engineered by China ahead of the Congress to give people something to rally behind.”
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