Investors may have been momentarily disappointed by the surprising news that Japan’s economy has contracted, but any doubt they may have had on the effectiveness of “Abenomics,” Japanese Prime Minister Shinzo Abe’s reform program aimed at rebuilding and reflating the economy, reversed quickly on the back of Abe’s swift response and evident commitment to the plan.
Abe used the third-quarter GDP news to call snap elections in an attempt to renew his mandate. The election “may be a calculated gamble to earn his administration four more years in office at a time when the opposition is bereft of ideas,” The Financial Times speculated.
With “Abenomics” still a reality and Abe himself likely to be in the lead for some time to come, here’s how investors see Japan.
GDP has nothing to do with stock market performance
For the past 20 years, the correlation between corporate earnings and GDP in Japan has been a mere 2%. And though nominal GDP has fallen by 7% since its 1997 peak, pre-tax recurring profits for Japanese corporates are up 104%, said Dale Winner, co-manager of the Wells Fargo Advantage International Equity Fund, “which means there’s really no link between overall GDP numbers and the Japanese market.” That makes Japan, already an overweight in Winner’s portfolio, an even more attractive investment opportunity that’s further bolstered by the ongoing fiscal stimulus, which has resulted in a significant decline in the yen and improved corporate profits.
The recent announcement in Japan that the country’s largest pension fund will be increasing its exposure toward domestic equities, has also increased the appeal of Japanese stocks, Winner said.“All in all, if you put things in context, it’s clear why we’re overweight Japan,” he said. “Not to mention that Japan also trades 20% than the U.S.”
More competitive companies that have yet to realize their full potential
In the aftermath of the global financial crisis, many Japanese corporations that had been hurt by the weakness in the U.S. dollar and the overall economic slowdown also initiated significant restructuring programs in order to lower costs and remain competitive. These endogenous efforts by corporates to improve their core competitiveness, coupled with more helpful exogenous global growth and currency conditions, have not yet been appreciated, said Vincent Musumeci, who manages the Henderson International Opportunities Fund Japan sub-portfolio”.
“Following on from efforts to structurally improve margins—which are still ongoing—we are now seeing the corporate sector improve its focus on capital management and we are now entering a phase where the Japanese listed corporate sector is structurally moving in the right direction in terms of margins, and gradually also now asset efficiency and leverage,” Musumeci said. “This is where the real opportunity lies, especially because Japanese corporate management teams are becoming enlightened towards the cost of capital and increasing dividends and share buybacks in order to lift RoE”
In conjunction with attractive valuations— and all this against a backdrop where the Japanese market has become appealing in terms of valuation versus the European Union and the U.S.—“we are seeing returns shifting higher and we believe that ‘Abenomics,’ as it represents the strong intent of government/bureaucracy and the central bank and corporate sector to rebuild the strategic strength of the nation via reflation and growth normalization, will continue unabated from a top down perspective,” Musumeci said. “This should generally be fundamentally supportive, in addition to what companies are doing for themselves and for their shareholders.” Winner also highlights the creation of the Nikkei Index 400, which focuses on companies with good corporate governance and high and recurring profitability, as an important step.
“An index that’s been deliberately created to include companies that follow good practices is key for the market, particularly since the Bank of Japan and the large pension funds will be tracking it as they put money to work,” he said.
Structural reforms yet to come as Abe increases mandate
Musumeci expects to see forthcoming reforms for the reconstitution of Japan’s energy sector, including the restarting of some nuclear plants, as well as corporate tax cuts as part of a broader program of tax system reform. Additional measures to assist more females to enter and stay in the workforce are an important step, too, he said, and should help to lift Japan’s GDP going forwar
But for Michael Ball, president and portfolio Manager of Weatherstone Capital Management, it’s still too early to bank entirely on Abenomics being a complete success.
Japan, much more than most countries, is driven largely by what economic policymakers can do rather than market forces, Ball said, and it faces some serious structural headwinds, particularly as Japan has lost its dominant position in both technology and manufacturing. Demographically, too, Japan is more challenged than other nations, since the aging of its population is a serious issue that would have economic repercussions.
Nevertheless, structural reforms to take a while to have any major effect, Ball said, and “the early signs in Japan are positive.”