In our view, the changes sweeping over Japan’s economy represent a major challenge to the pessimism which has long prevailed among investor opinion on the country. 
Beginning with the structural and macro changes of prime minister Shinzo Abe’s ‘three arrows’, down to company-level trends such as strengthening balance sheets and improving corporate governance, we think Japan’s economy today scarcely resembles the difficult environment of the past – and we think that creates the potential to deliver attractive investment opportunities for the discerning investor.
Let’s begin with the structural changes. We believe Abe’s monetary and fiscal policies have helped pull Japan out of deflation and have set the economy on a positive (if only modestly positive) growth trajectory, with actual GDP growth of 1 per cent expected in 2016.
This growth is a small tailwind for Japanese corporate earnings, and therefore has the potential to drive equity prices – but we would stress that a modest tailwind is nevertheless a sharp contrast to the giant macro challenges of the past.
Performance of index over 3yrs
Source: FE Analytics
While those macro changes are well known, perhaps less widely recognised are the major changes underway in Abe’s third arrow – corporate governance – as well as important, favourable changes in consumption patterns.
There is today a corporate focus on shareholder returns for the first time in recent memory, thanks to the reforms pushed by the third arrow.
These reforms include independent board members, requirements for return on equity (ROE), and broader efforts to modernize Japanese corporate governance. They have contributed to an environment where consensus forecasts call for earnings growth to roughly match Europe’s – a sharp contrast to the fragility of years past.
Now to the consumer.
Besides the progress in corporate balance sheets, Japanese companies and their share prices are watching what used to be a range of domestic headwinds turn into tailwinds.
Household consumption has increased in four of the past five quarters and, in our view, will be supported in 2016 by further gains in real household disposable income, which looks set to benefit simultaneously from rising real wage growth and from a continued decline in unemployment.
The decline in the yen has led to a tourism influx.
Performance of currency over 3yrs
Source: FE Analytics
Households also continue to diversify assets into equities, with further to go if Japan reaches the developed-world norm: About 50 per cent of Japanese household assets are in cash, versus 35 per cent in Europe and only 13 per cent in the US.
It bears mention that the changes in household investment patterns are not the only tailwind in financial markets. For instance, Japan’s GPIF, the largest pension fund in the world, has increased its domestic equity allocation to more than 23 per cent as of mid-2015 (with a target allocation of 25 per cent) from 17.3 per cent in June 2014.
Three other government pension funds have followed, providing an institutional bid to Japan’s equity markets. We believe corporate pension plans may be next.
Changes such as these have created what we view as a renaissance in micro-level opportunity in Japan.
Corporate profitability is already near record levels, a feat which has been accomplished even as Japanese companies are flush with cash and their balance sheets appear the healthiest in two decades. Looking to next year, we expect Japan’s earnings growth for fiscal year 2016 in the high single digits.
To be sure, Japan’s modestly improving macro context is one of incremental improvements. Challenges still remain from a policy perspective – both around enhancing the transmission of BoJ monetary stimulus into the real economy, and around implementing a credible medium-term plan for fiscal consolidation – but the pro-reform agenda being advanced by Abe has already generated meaningful progress, and the micro picture today is more favourable than many investors realize.
In a global equity market of fair (in many cases full) valuations, we see these trends in combination as an attractive potential driver of stock prices and the catalyst for investors to reassess their view of Japan’s economy and markets.
James Ashley is head of international market strategy in the strategic advisory solutions at Goldman Sachs Asset Management. The views expressed above are his own and should not be taken as investment advice.
