The investment case for Japan continues to divide investors many of whom have been burnt in the past by a market that has struggled with deflation and less impactful than expected monetary policy.
Yet, Schroders client portfolio manager Nathan Gibbs said he is excited for the future of the Japanese market, even though economic growth has been slower to come through than he would have expected.
“I would suggest that things are heading in generally the right direction but it is slow and I think a lot of investors need to see more evidence before they invest in Japan because they have been burnt,” the portfolio manager who works on funds including Schroder Tokyo said.
Performance of index since 1980
Source: FE Analytics
Gibbs said a cornerstone of ‘Abenomics’ – the economic policies advocated by Japanese prime minister Shinzo Abe – was the introduction of quantitative easing in 2012.
“It was a big change in 2012 after 10 years of doing very little in terms of monetary and fiscal policy,” he explained.
“Japan embarked on this attempt to get out of deflation and foreign investors particularly got very excited about that and then after about three years got bored with the whole thing because the results hadn’t come through.
“I think the data suggests to us that those results are coming through and though it is slow it is pretty progressive now.”
Indeed, in the second quarter of this year Japan’s GDP grew by 1 per cent and by 4 per cent on an annualised basis.
“That is the sixth consecutive quarter of GDP growth in Japan; I’m quite excited about that. That is the first time that has happened in more than 10 years,” Gibbs noted.
Meanwhile, inflation remains very low but consensus expects that rate to tick up over the next 12 months to somewhere between 1 and 1.5 per cent, a level Gibbs is comfortable with and much better than the deflationary environment seen for many years.
“We are not suddenly going to wake up and find that Japan is suddenly growing at 4-5 per cent per annum but lots of these indicators are moving from just negative to just positive whether it is inflation, wages consumer confidence etc and the move from -0.5 to +0.5 is much more significant from +0.5-1.5,” the portfolio manager said.
Despite these improving macroeconomic data points, investors have been slow to react to this with parts of the market being de-rated rather than upgraded.
“We haven’t been particularly surprised about what has happened with the economy though we think it is positive, but the market just hasn’t reacted to it,” he noted. 
“So, the gap between our expectations and what the market has priced in has got bigger so we are more excited about Japan than we were.”
Part of the reason for this dispersion is concerns over outside factors such as US protectionist policies and increased scrutiny on North Korean tensions.
While sentiment has been positive, Gibbs said it would be fairly easy for something to outweigh these economic data points.
“So, it is a fairly fragile situation we are in and Japan is particularly at risk from US protectionist moves,” the manager added.
“Japan has one of the largest trade surpluses with the US and a significant part of that is still in autos which is a very easy target if president Trump wakes up one morning and decides that he doesn’t like that number.”
Meanwhile, increased tensions with North Korea may be grabbing headline inches but they are nothing new in Japan.
“For Japan, this has been a risk for decades. The US has finally woken up to this because North Korea has developed long-range missiles but Japan has been in range of short-range missiles since the year dot,” Gibbs said.
“What is different is that the US from Japan’s perspective is being much more isolationist, is not trying to form a consensus within Asia in the way it has done previously.
“Now I think Japan and South Korea are faced with a situation where they have to work on their own rather than being in-step with the US.”
However, while these risks are there a strong earnings reporting season in the last few months that has “redressed the balance a little bit”, the manager noted.
As such, for investors looking to gain access to the market he suggested looking to domestic cyclicals which should particularly benefit from any boost in inflation.
“Japan over a long period is the market that most clearly moves with value and as a style value outperforms on almost every empirical study,” he said.
“Value is the style that does best in Japan and more consistently than it does in other markets. Having said that the last few years have been unusual in that value has underperformed for quite significant parts for the last three years.
Performance of indices over 3yrs
Source: FE Analytics
Gibbs highlighted: “I think that is more around what has been going on with monetary policy and the fact that markets have been so macro-driven, policy-driven and all that big picture top down stuff has overwhelmed the individual stock valuations for much longer than we would normally expect to happen.
“That stock specific nature has rather disappeared and that I think is what typically drives the value outperformance in Japan.
“Going forward we do expect to see it revert to its normal and within the last couple of months as we have come through the earnings reporting season we have definitely seen much more stock specific nature in Japan again.”
As such, the manager said domestically-focused cyclicals are the way to invest in Japan in the coming years, with the retailers a particularly interesting area.
“The biggest surprises are coming in the domestic economy where investors had just written off Japan and said it was really boring as they have poor demographics and very low growth,” he said.
Growth is still higher for some of the exporters in the market, much of this is priced in, he added, but the domestic names have been a pleasant surprise and investors have been slow to recognise this.
“Japan has been in deflation for 15 years. Prices have been falling so if you build earnings models as we do for the companies you have been consistently putting in a declining top line.
“Retailers who have survived the last 15 years in Japan are really pretty efficient because every month and every quarter they have reduced the sticker price.
“Now if you go to them and say to them if that top line up by 1 per cent they will tell you it is just a breeze.
“What we actually mean by that is operational gearing is now very high in Japan, they’re efficient, they have got their inventory under control, they have been cutting costs for 15 years and now if the top line grows as a result of reflation then the impact on profits is big.”