The Outlook Remains Positive for Japan Despite Economic Challenges
By Akira Fuse
Capital Group Investment Specialist
Prime Minister Shinzo Abe came into office two years ago with a bold plan to reinvigorate Japan’s struggling economy. He undertook aggressive stimulus measures and structural reforms to combat weak consumer confidence, stagnant wages and chronic deflationary pressures. A key goal of what has been dubbed Abenomics was to break a years-long aversion to spending and risk-taking among consumers and businesses. Though the government’s efforts are far from complete, signs of progress have begun to emerge, including rising corporate profits and improved job growth.
Lately, Abenomics has encountered significant headwinds, including a brief recession last year. The economic strains aren’t surprising, given the challenge of reversing a deflationary mindset that has taken hold in Japan over the past 15 years. However, I believe the outlook is more encouraging than it might seem. First, Abenomics has brought about important structural changes — primarily in the area of corporate governance — that bode well for the future. Second, just as the Federal Reserve is ending its quantitative easing program in the U.S., the Bank of Japan (BOJ) and the government are ramping up stimulus measures that should help the country emerge from its lengthy malaise.
It’s also important to point out that, despite setbacks in the domestic economy, many Japanese companies, especially those with sizable export-oriented operations, have prospered. Careful on-the-ground research by Capital Group analysts has identified a number of companies with proprietary technologies in leading-edge industries such as factory automation and robotics. Many of these companies are globally oriented and derive a large portion of their revenue outside Japan. For example, there is significant demand for factory automation in China.
The push for improved corporate governance is one of the biggest changes to come from Abenomics. For years, shareholder rights in Japan lagged behind even those of the emerging markets, and past attempts at reform went nowhere. Abe has championed governance as a central element of his growth strategy because he believes companies have scared off investors by hoarding cash and producing low returns on equity (ROE). In meetings with Capital Group analysts, government officials and many corporate managements have pledged their commitment to boost ROE.
The government has introduced a stewardship code that encourages institutional investors to speak out about deficiencies in shareholder policies. The government is also drafting a first-ever corporate governance code to urge companies to increase the independence of their boards. Though voluntary, this code would nonetheless carry weight because companies that do not comply would be required to provide an explanation. Partly because of this, the share of blue-chip companies with outside directors rose above 74% in 2014, more than double the level of a decade earlier.
Meanwhile, the Tokyo Stock Exchange has launched a new market index — the JPX-Nikkei Index 400 — made up of the most profitable and investor-friendly companies. The none-too-subtle message is that companies must improve governance if they want to be counted among the country’s elite and have the greatest appeal to investors. Such reforms are having the desired effect of pressuring Japanese companies to increase dividends and share repurchases. Not surprisingly, combined buybacks and dividends approached record highs in 2014.
As for Japan’s domestic economy, the picture is less bright. The world’s third-largest economy briefly slipped into recession in the middle of last year. Much of the decline, however, was caused by an ill-timed sales tax hike a year ago that spurred consumers to front-load their purchases before the new taxes took effect. The tax also prompted companies to reduce inventories in anticipation of lower consumer demand. Economic growth resumed in the fourth quarter as exports rose. However, the 2.2% annualized GDP growth rate was lower than expected.A sales tax increase from 5% to 8% was intended to chip away at the government’s huge debt, which, at more than twice the size of the economy, is the highest in the developed world. But the disappointing GDP caused Abe to postpone a further sales tax increase to 10% that had been set to take effect this coming October. The second hike was pushed back to April 2017, removing a near-term financial and psychological impediment.
The BOJ and the government have unveiled dramatic new steps that are likely to spur growth. The central bank surprised the financial markets by announcing an increase in the size of its already enormous stimulus program. Besides pumping trillions more yen into the economy, the BOJ is buying longer-dated, less liquid and riskier assets. That is being augmented by a companion effort at the Government Pension Investment Fund. The fund announced that it is changing its strategic asset allocation toward risk assets such as Japanese stocks, as well as foreign equity and bonds. Other Japanese pension funds are likely to follow, providing a boost to the equity market. The government is expected to provide additional stimulus measures of its own.
The stimulus campaign is likely to exert further downward pressure on the yen, which is at a multi-year low against the dollar. That would boost the profits of large exporters. A silver lining in Japan’s long-standing woes is that exporters and domestic manufacturers have become more efficient. Reduced operating costs allow goods to be priced more competitively against global rivals. As a result, the average prices of big-ticket items made in Japan are actually lower than those of Chinese imports.
Certainly, Japan still faces many obstacles. The corporate governance reforms must prove to be more than lip service. The national debt remains high, and the country’s aging population could be a drag on the economy. Finally, the government’s ultimate goal — to create a consumer-driven culture in which rising corporate earnings lead to higher wages and more investment — is far from a reality.
Nevertheless, I believe there are compelling investment opportunities among select Japanese companies. For instance, despite higher valuations, the long-term outlook remains favorable for automation and robotics companies. Growing automobile and aircraft demand bodes well for engine manufacturers and component makers. And an improving economy would help large banks if loan growth picks up and profit margins rise.
Akira Fuse is an investment specialist focusing on Japanese stocks. Based in Tokyo, he has 26 years of investment experience and has been with Capital Group since 2008.