Do you think that the efforts of the Abe government and the Bank of Japan to reflate the economy will succeed?
There are some significant structural issues that Japan has to fix in order to see sustained economic growth over the longer term. If the government is indeed willing to tackle the structural issues — and it is a big “if” — then you could see even greater upward movement in the equity markets. What we have seen so far may just be the beginning. There is a good deal of money on the sidelines, both from foreign institutional investors, but more importantly from retail and institutional investors within Japan. These domestic investors are the most skeptical of what has gone on because they are living through it. They understand how tough things are at their companies, and although they have seen a weaker yen, it has not been accompanied by wage increases.
Right now they don’t appear to be convinced, but if they perceive signs of positive structural change, we could see a large reallocation of assets from the domestic bond market — which is several times the size of the equity market — to equities. But it is still too early to tell whether this will happen. Even if it does occur, it would be a multiyear event, which is why we are evaluating opportunities in Japan just as we do anywhere in the world: based on a long-term perspective, not on short-term events.
The key thing that everyone is watching in the near term, of course, is the upper house elections in July. If the existing government can get a majority in the upper house then it will control both houses and we may begin to see some progress on more meaningful structural reforms. But restructuring the economy will not be easy; the reforms needed to make sectors more efficient, including deregulation and privatization, are politically difficult.
How do you view the sharp equity market rally we have seen so far this year, with Japan among the best of the developed markets?
In some sense, it is pure asset inflation. Nominal interest rates have been close to zero for many years. However, because of the deflationary environment, real interest rates have been close to 2% — which is relatively high when real interest rates in many other developed economies have been flat to negative. With this new monetary policy creating an expectation that the central bank is going to target 2% inflation and therefore much lower real interest rates, then naturally the prices of financial assets and some real assets will rise sharply, including real estate. That is why real estate stocks were the very first sector to lead the market.
That in turn caused the yen to depreciate, which is the reason why the second set of companies that went up a lot were the exporters. When the real estate sector and the export sector go up, you build in expectations that local consumption-based companies that have suffered from deflation over the years will also get a bit of help on the top line. That represents a big chunk of the market in which investor expectations have changed substantially, and there you have a market rally.
Are there any early signs that this government will simultaneously tackle some structural reforms?
Joining the Trans-Pacific Partnership negotiations was a very positive step toward reform. Japan’s agricultural sector has been subsidized for decades and has taken a lot of government resources. One could argue that a big chunk of the agricultural part of the economy might be at risk by opening up trade with the other nations involved in the TPP. And this could be a painful transition for what has been a steadfast support base for the Liberal Democratic Party among farmers and the agricultural sector. Despite this, Abe is really pushing for the TPP. It shows that he is willing to take some pain from his most ardent supporters in order to do what the country really needs, which is deregulation and reform of some of the most inefficient sectors of the economy. So that is a very positive sign.
How much of an impact will a devaluation of the yen have on Japanese companies?
The impact of a depreciating yen is very company-specific. The idea that the devaluation of the yen will cause all Japanese stocks to go up is simply incorrect. For instance, you have the export sector, which historically may have seen enormous benefits from yen weakening because the companies had dollar-based revenue and yen-based costs. However, many of these companies — particularly the electronics and auto companies — have really localized production over the last 15 to 20 years, moving large portions of it overseas. For some of these companies, the weakening of the yen now has almost a negligible effect on their profit-and-loss statements.
The majority of companies in Japan are domestically focused — they have yen-based revenues and yen-based costs. So, the primary impact of a weak yen would be that they import cost inflation, which could actually compress margins. For instance, electricity prices have been going up because the country has relied so heavily on fuel imports to meet its energy needs since the shutdown of nearly all nuclear power plants. Some retailers, in particular the supermarket chains, are already saying that they are seeing food inflation, and this is concerning because Japanese consumers have not yet seen wage increases to match rising prices. So things are not very positive for these companies at the moment.
Overseas Production Has Diminished the Benefits of a Weak Yen on Exporters
How would you characterize your investments in Japan?
The common factor among my holdings in Japan is that they are all well-run companies with good management teams that can succeed regardless of the macroeconomic situation. The areas I am most interested in and my holdings in Japan reflect much more global themes, with the most prominent being mobile computing.
When it comes to mobile computing, many of the difficult-to-manufacture components that go inside smartphones and tablets — everything from the display to the radio devices that filter out frequencies — are made in Japan.
Those precision manufacturing–type companies, I believe, have a very bright future ahead of them as the trend toward on-the-go computing continues.
In terms of the telecommunication services sector, some of the trends that you have seen in the U.S. are beginning to emerge in Asia. The biggest is tier pricing, which is a result of the willingness of the Japanese consumer to pay higher prices for better connectivity, increased data and faster performance. The other thing that makes me positive about the telco sector in Japan is that it is very consolidated and the companies are competing wisely. They are using the limited competition to produce higher prices instead of competing away the price, thus increasing their margins.
Has the market rally caused you to make any substantial changes to your Japanese holdings?
I have always believed that companies should be viewed on their own merits, and I have long admired many companies in Japan, a large number of which operate under very difficult conditions. The exporters have historically suffered because of the strength of the yen, while the domestic companies have struggled because of deflation. Despite this, there are many companies with good management teams that have had consistent earnings growth — and I have tried to hold these companies in my portfolio, even before the start of Abenomics. These companies have done quite well during the recent market rally, but I have not made major changes to the portfolio.
What is your impression of how Japan’s corporate management has reacted toward all of the fiscal and monetary actions that have been undertaken in Japan?
I get a sense that company managements are hopeful that there is finally some real change at hand, but they maintain a healthy dose of skepticism because 15 to 20 years of deflation is not something that can easily be turned around. At this time, I do not get the sense that they are taking any action or changing what they are doing in light of the recent policy measures.
We do have a big trip coming up in May visit some domestic companies. In our meetings, we will try and assess whether the management teams are going to do anything to position their companies differently in this market and get their insights as to whether they see sustainable change occurring in the economy. That will give us a good sense of whether we need to change the portfolio to be more domestic rather than export-oriented. Again, it is important to remember that the effects of Abenomics may not be felt for two to three years, so we want to make sure that our portfolios reflect companies that provide good long-term value for our clients.
Japanese banks are a small portion of the EuroPacific Growth Fund’s Japanese holdings, which are more focused on the exporters, including the automakers, telecommunications and information technology companies. Recently some portfolio managers have begun reassessing these opportunities. What could make these banks good long-term investments?
The Japanese banks get a slightly unfair rap. In fact, the banks are well-managed and don’t tend to make foolish investments overseas. They had their share of problems in the late 1980s when the bubble burst, but that led to massive reform and consolidation in the industry. They learned from these experiences and didn’t get involved in purchasing toxic assets during the recent financial crisis, allowing them to escape largely unharmed.
The biggest problem for these banks is that, because the domestic economy isn’t growing, there is insufficient demand for loans. These banks are flush with cash, but they have no place to lend their money and no opportunity to earn return on their assets because they have so little pricing power. If structural changes occur in Japan and the domestic economy improves, demand for loans could increase. The banks could finally put this excess capital to more efficient use and earn some return on it, making them more attractive long-term investments.
What impact could a sustained reflation have on real estate companies in Japan?
Japan is in an interesting position because it was one of the first countries to go to a zero interest rate — yet because of deflation, real interest rates have been high, making borrowing very expensive. Individuals and companies have been hesitant to invest their cash in real estate because they have no incentive to do so. They can still get decent returns with very little risk just by investing in Japanese government bonds in a deflationary environment. So, if they can achieve a 2% inflation rate, the Japanese government will essentially be lowering the real interest rate, which could benefit real asset-based prices, including in the real estate sector.
We have already begun to see this reflected in the share prices for some of these companies. Real estate has led the rally in Japanese equities purely based on the expectation that these companies will see higher net asset values of their holdings. But if the targeted inflation doesn’t materialize, the market could be disappointed because those lofty expectations are already built in. It is important to remember that the effects of what is going on in Japan may not be felt for a couple of years. So, even with real estate, you still need to look at each company individually to assess its potential given its valuation.
Is there anything that makes you cautious about investing in Japan?
The fact that some of the sectors in Japan are extremely inefficient can sometimes make otherwise well-managed businesses unattractive. When you look at the larger companies, they do well because they are well managed and have scale, yet when you compare them to their global peers, they never look attractive because their margins are so much smaller. This is because there are hundreds of other inefficient companies in their sector supported by the government through tax breaks and subsidies that are chipping away at their market share.
The restructuring and industry consolidation in the telecommunication services and financial sectors has helped make companies in those sectors much more profitable. Companies in other sectors in Japan could really benefit from structural changes aimed at increasing efficiency.
Are you hedging the Japanese investments in the portfolio?
In equity portfolios, we generally don’t hedge currencies unless we have a strong view. It is also important to remember that many of these companies are hedged themselves, which often negates your own hedging. In the past, some portfolio managers that had predominantly domestic-oriented companies hedged their positions, but at the moment we don’t have a large hedge in place.