The fall and rise of Japan

Once a global star performer, Japan has endured years of economic strife - but has Abenomics brought about a return to prosperity and opportunities for investors? David Burrows investigates

For most of the last decade, if not even before that, the Japanese economy has been regarded as a basket case, with the Nikkei something of a dog and economic growth nowhere to be seen.

That has changed in recent years - in 2012 the Nikkei was up 26 per cent, and 52 per cent in 2013. In 2014 the market has been more volatile, but as Michael Paul, Japan and Asia Equity Analyst at Brewin Dolphin, argues, there is good reason to be positive on Japan.

“The market has seen more volatility in 2014, but that has largely been due to the VAT hike introduced in April 2014,” he explains. “A lot of purchases were brought forward to the first quarter, prior to the VAT rise, which meant a weaker second quarter. Also a lot of big macro funds took money out of Japan at the start of the year, not only on the basis that they had performed well, but also because of the uncertainty over VAT.”

Paul insists the underlying story remains intact, however, and that the reforms introduced by Japanese Prime Minister Shinzo Abe - monetary, fiscal and structural - are working and making Japan a more attractive place to invest (see box).

A more bullish sentiment towards Japan is certainly reflected in the flows of money into Japanese funds since Abe was elected in 2012. Net retail sales figures from the Investment Managers Association show that while there were outflows of £40.6 million from Japanese funds in 2012, for 2013, post-election and following the implementation of Abenomics, there were inflows of £636 million.

The move into Japanese equities has been justified in performance numbers too. According to Morningstar, the average two-year return from funds in the Japan sector to 31 August 2014 was 17.01 per cent.

Andrew Pittom, Director at Moore Management, also believes there remains good reason for investor optimism towards Japan. “The Nikkei performed well at the end of 2013 - it has slipped into negative territory since then, but it remains a good story and things are still moving in the right direction.” Echoing Brewin Dolphin"s Paul, he says: “Money was withdrawn at the start of 2014, but this was largely profit realisation rather than the start of any downturn - Japan funds are still selling well.”

Credit for Abe

So, just how much does Japan"s recovery owe to the impact of Abenomics? Well, a great deal, according to Ian Heslop, Head of Global Equities at Old Mutual. “I would say the recovery is indeed on the back of Abenomics. In 2012 we saw a change in government, a change in fiscal and monetary policy and a change in risk appetite from Japanese investors. Valuations of Japanese equities aren"t massively expensive and there"s still growth potential. Core inflation is going in the right direction. The Japanese economy has come a long way in 18 months.”

Heslop concedes there"s no shortage of challenges ahead - not least the earning and spending power of Japanese workers. “We"ve yet to see much in the way of wage inflation. We"ve seen some in large cap companies, but that"s mainly on the back of bonuses rather than fixed costs. There"s been no noticeable wage inflation among smaller companies. But if revenues continue to improve, we should see wage inflation.” A more affluent consumer would prove an added boost to Japanese manufacturers and retailers focused on the domestic market.

Abenomics also succeeded in intentionally weakening the yen. But has Japan enjoyed increased export business as a consequence? And, if so, has the growth been in specific sectors?

“There has been a growth in exports in automotive and tech companies due in some part to the weaker yen, but exports in general aren"t seeing a major pick up,” Pittom says.

His view is echoed by Paul. “Export growth expectations have had to be revised. We"ve seen roughly a 25 per cent weakening in the yen - this has meant companies have been able to cut costs. They"ve maintained rather than increased their market share, but have become more profitable.” He adds that the Japanese export story has changed markedly over the last decade. “Exports aren"t such a big part of corporate Japan anymore. A lot of manufacturers are building their products close to where they"re selling in overseas markets. There"s much more international businesses now, which means there is the opportunity for earnings overseas to be brought back into Japan at a more beneficial exchange rate.”

Japan was once the world leader in the technology sector, but fell behind. While it"s still ahead of the pack in certain areas, like robotics, other countries, particularly in Asia, have either overtaken or closed the gap on their neighbour. Pittom believes Japan remains competitive, but agrees that other countries are constantly raising the bar.

“Japan must continually look to improve price and product, with countries like Korea competing hard,” he explains. “However, I think Japan has the advantage in brands and quality. In the automotive and tech sectors, there"s still strong growth, and companies in those sectors are increasing margins.”

A good time to invest?

It"s been a good two years for investors in Japan, but is now a good time to either enter or increase exposure to that stock market? Heslop thinks it"s reasonable to say the easy money has been made in Japan now. Going forward, the prospects for listed Japanese companies will depend on whether the structural reforms promised by the government materialise - particularly in relation to moving tariffs, improving corporate governance and focusing on shareholder value.

“Japan is a "seen it before" story,” says Heslop. “People who have made allocation shifts into Japan in the past have been disappointed.” For an economy that has been stagnant for so long, there"s understandable scepticism about any long-term recovery. Heslop, however, thinks if the progress seen since 2012 continues, there"s likely to be a more sustained move into Japanese equities.

Paul suggests that while valuations of Japanese shares still look attractive from a global perspective, the shrewd investor will access the country via a collective fund rather than individual shares, and possibly in a broader Asian or global fund. “Broker coverage in Japan is quite low, so a good fund management team can find some interesting stories and uncover companies that are attractive but largely overlooked.”

As for the outlook over the next two years, major tests lie ahead for Abe. While his monetary and fiscal policy has produced tangible results, he has yet to make any significant headway in structural reform.

Historically, Japan is an enclosed economy - it"s not a very open or liquid market. There are many large family-owned businesses in Japan, and there has traditionally been a reluctance from Japanese companies to focus on shareholder value.

What"s more, many Japanese businesses aren"t open to the idea of partnering with foreign companies, or comfortable with foreign financing. Improving international trade associations is part of Abe"s structural reforms, but, as Pittom says, unlike the monetary and fiscal policies, which have more immediate impact, this is a longer-term objective that will require something of a cultural shift.

“The Japanese ambassador came to Jersey in 2013 and there was much talk about business zones and opening up the market in Japan. The business zones in Tokyo are designated areas where it"s much easier for western companies to set up and work,” Pittom explains. “We know from experience that setting up an office in Tokyo can be quite problematic, so at least this is progress.”

Pittom"s cautious optimism is shared by Paul, particularly in relation to corporate Japan. “Corporate governance in Japan has historically been a problem, but it"s improving,” he says. “I think the new Nikkei 400 Index is a step forward as it forces companies to focus on transparency and returns to shareholders - companies listed must satisfy global investment standards. It"s often referred to as the "shame index" on the grounds that there"s shame if you aren"t on it.”

For Heslop, further positive momentum from Abenomics in the future depends on the level of opposition the Prime Minister faces on structural reform. “It will take a lot of political bravery to see his reforms through, particularly the restructuring of the healthcare and agricultural sectors, which have been very protected by current policies - with huge tariffs on rice into Japan, for example.”

Heslop believes Abe has a once-in-a-generation opportunity to introduce radical structural changes, and the success of his monetary and fiscal policy means he has some measure of support for what comes next, but his popularity rating will take a hit as this tough medicine is swallowed. He has a mandate to govern for another two years, which gives him time to implement changes - the question is: how far will he go?