The successes of Japan’s corporate governance reforms and the market’s renewed attraction for investors are no secret. Despite the positive sentiment towards Japanese equities in recent years, the market suffered a shock in early August, experiencing its worst day since 1987 with the Nikkei plunging 12% on the 6th, while the Topix recorded its second-largest three-day drawdown ever in the days that followed.
Many factors were identified in the aftermath of the correction, including concerns over the US economy following a weaker-than-expected unemployment report. The volatility also placed the Bank of Japan’s (BoJ’s) surprise interest rate rise to 0.25% at the end of July under the microscope, with the unwinding of the dollar-yen carry trade exacerbating the selloff.
Overall, have recent policy decisions from the BoJ, coupled with currency risk, changed the way investors are allocating to the country?
Carry trades and cappuccino
The move to end the zero interest rate policy was a major decision for the central bank. David Mitchinson, fund manager at Zennor Asset Management, says that in practice, the move is “part and parcel of Japan becoming a normal country again” in which capital has some cost.
“For many years the flow of capital, assets and people in Japan stalled – enabled by cost-free finance. Too much investment and talent has become stuck in the wrong places and a more dynamic economy will be able to increase productivity, wages and wealth.”
Due to the interest rate differential that has persisted between the US and Japan, borrowing yen to buy dollars has been lucrative in recent years.
However, the BoJ’s move to raise interest rates in order to strengthen the yen – at a time when most major central banks are looking to cut rates – prompted the carry trade to begin to unravel, contributing to the market selloff.
Despite the short-term volatility, however, a stronger yen could further enhance the positive outlook for investing in Japan.
In July, Stefan Sommerville, investment counsellor at Orbis Investments, noted that, should the yen strengthen and the dollar wobble, cracks could very quickly begin to show in the carry trade.
“If the yen were to strengthen from 150 to, say, 125 against the dollar, a US investor in Japan’s market would pocket a 20% return, even if stockmarkets are flat.”
See also: Hidden gems: Six below-radar funds in the Japan sector
Zennor’s Mitchinson also believes the yen is “profoundly undervalued”. “Our Starbucks Cappuccino indicator suggests that coffee in central Tokyo is roughly half the price it is in London – this feels broadly right across many goods and services,” he says.
“While a weak yen may help some industries such as autos, the reality is that Japan is a rather domestic economy and has largely balanced its production with where its customers are.
“In time, we expect a stronger yen would help our companies and the Japanese consumers to which they are exposed,” he adds.
Mitchinson, who runs the Zennor Japan and Japan Equity Income funds alongside James Salter, viewed the market correction in early August as a buying opportunity.
“We started with around 5% in cash and have deployed most of it during the selloff. We used the cash on hand to add to several positions, including in Genda and Secom where we felt the selloff was grossly excessive. We have had several companies on our watch for some time and after the share price drops, we felt they offered an attractive valuation.
“One example is software service company Simplex. Historically, this company has traded in the mid-20x PE ratio reflecting its strong growth and profitability. After the selloff this declined to a low-teens multiple while the structural growth opportunity remains intact.”
See also: Man Group’s Emily Badger: What positive interest rates means for Japan financials
Omar Malik, global equity portfolio manager at Hosking Partners, says his team’s bullish outlook for the opportunity in Japan remains unchanged by the recent market volatility in the wake of the BoJ raising interest rates. The firm owns small to mid-cap stocks in Japan with net cash balance sheets which they believe have a clear path to benefit from corporate governance reform.
“Given the recent move in USD-JPY yield differentials, we don’t think the BoJ decision should have been a surprise, but the selloff in Japanese equities following the rate hike was more surprising on the back of fears around the impact of a stronger yen,” Malik says.
Read the rest of this article in the September issue of Portfolio Adviser magazine
