Lost decade begins to work in Japan’s favour

The investment case for Japan is centred on the belief that the Bank of Japan, against a deflationary headwind, will be the last of the world’s central banks to abandon loose monetary policy. The authorities have learnt from past mistakes.

A more pro-Japanese equity environment will be brought about by the current contrast in loose monetary policy in Japan compared with a tightening policy in the Asia ex Japan region.

While Japan’s economy in the 1990s has come to be referred to as "the lost decade", the reality is that Japan actually experienced modest real GDP growth. Indeed it could be argued that the levels of growth would have been even more respectable had the government at the time not choked off the potential for further growth by prematurely tightening fiscal policy, which forced the economy into periods of recession.

Additionally, many of Japan’s bad practices are coming to an end. The corporate sector has had a reputation of diluting shareholder returns with equity issuance and excessive capital investment. Returns on capital have been squeezed and companies have struggled to be competitive globally, not helped by a currency perceived to be expensive on a flat-line basis.

Change now appears to be forthcoming. Companies have reacted to the lower growth environment by rotating away from domestic investment and into foreign markets, leveraging off the growth story unfolding in Asia. Economic growth in the continent is forecast to be strong, and with approximately 60 per cent of exports going directly to Asian countries, Japan’s neighbours are becoming an important customer. Japan should perhaps be seen as a corporately rich Asian economy.

One criticism aimed at Japanese companies in the past was that they hoarded cash. While Japan’s household sector has run down its savings to less than 3 per cent of disposable income, the national savings rate, buoyed by an increase in corporate savings, is up at about 25 per cent.

In a shareholder-unfriendly governance system, Japanese companies distribute much less by way of dividends and buy-backs than their western counterparts. However, the yield on the Topix index is now a healthy 2.23 per cent (a yield over government bonds of 1.25 per cent). Additionally, Japanese company buy-backs could more than double this year. Admittedly this is from a very low base, their lowest level in nearly a decade, but it is welcome news.

With the Topix trading at below price-to-book valuation (the lowest valuation of the index in more than 40 years) it presents investors with an enticing entry point into the equity market, offering a degree of downside protection.

Negative investor sentiment remains allied to a difficult trading outlook. It is an untruth, though, that Japanese companies have little growth potential. Companies in the Topix have achieved EPS growth of 200 per cent since the peak of the technology bubble in 1999.

However, there has always been a question about how far growth converts into shareholder returns. A governance survey from Credit Lyonnais Securities Asia (CLSA) stated that Japan has recently witnessed the fastest improvements in corporate governance.

It is well known that Japanese government bonds (JGBs) are over-owned within the domestic financial system; the flipside is that Japanese equities are massively under-owned.

Japan Post Bank, owner of about one-fifth of all JGBs, has stated its intent to diversify its asset pool by increasing the equity allocation. Even a modest inflow of assets into domestic equities will be supportive of prices. Foreign capital inflows have tended to drive the Japanese market, and despite the recent inflow into exchange traded funds (ETFs), equities in Japan still represent an underweight position in the majority of global portfolios.

Although the banking system is not facing the severe stresses of western banks, the level of public sector debt is frightening, currently standing at 208 per cent of GDP.

In a slow-growth environment it will be hard for the authorities to reduce the quantum of debt without an uptick in inflation. Yet the positive news here is that the debt is substantially owned by domestic investors, which means that no one should care much for the observations of the ratings agencies, nor does the country face pressure from foreign investors to address the issue.

Our CF Miton Special Situations Portfolio has historically had a reputation for being non-consensual, buying unloved assets ahead of a re-rating. The exposure to Japanese equities is the second-largest equity allocation in the portfolio, representing 6.9 per cent of net asset value – evidence of our belief that if one is to be exposed to risk assets at this stage in the cycle, Japanese equities are as compelling as any.

James Sullivan is co-manager of the CF Miton Special Situations Portfolio. The views expressed here are his own.