“Progress in Japan is rarely straightforward. Some areas jump ahead, and others are a bit behind. Its firms sometimes struggle with dynamic change.”
The words of Baillie Gifford Japan Trust manager Matthew Brett summarise many fund selectors’ view on Japan in the last three decades. For me, it’s almost a case of the more things change, the more they stay the same.
Yet again, change is in the air. The third quarter of 2021 was a particularly busy one for the Japanese government as it sought to limit the spread of Covid-19 and prepare for an Olympic Games most of the country did not want. Many expected the results to dictate the prospects of the ruling Liberal Democratic Party (LDP).
Fast forward to the end of the quarter and a general election is on the horizon with prime minister Yoshihide Suga having already announced that he will not stand in the leadership election for his party. His intention to step down comes only a year after replacing Shinzo Abe.
While there is little doubt the LDP will win the election later this year, the prospect of losing more seats and having to cede more power in coalition is something the party was keen to nip in the bud as early as possible.
At the time of writing, there are three front runners to take over the LDP in the shape of former foreign minister Fumio Kishida, who was previously considered an heir to Abe. Abe’s former internal affairs minister Sanae Takaichi who, if elected, would become Japan’s first female prime minister; and Japan’s vaccination programme leader Taro Kono.
So, who would be best for markets? The truth is, Suga was no disaster. A recent note from Jupiter points to ideas like the establishment of a digital agency and the mandate for genuine structural reform being well founded – although overlooked by the Olympic and pandemic challenges. The note adds that both Kono and Kishida would be pro-market prime ministers.
What prospects for Japanese equities?
The Japanese equity market has underperformed other developed markets this year, having fallen significantly between February and May. But since late August – and especially since Suga’s announcement – it has rallied. It is now back in the black, up almost 2% year to date, compared with 16% for global equities*.
Matthews Asia portfolio manager Shuntaro Takeuchi believes Japan is poised for a comeback, driven by earnings momentum – adding that countries linked to the global economy, like Japan, should fare better going forwards as prospects for exports improve.
Takeuchi says the earnings capability of Japanese companies has improved meaningfully over the past economic cycle, driven by better corporate governance and a higher focus on capital efficiency. He feels multi-year trends such as productivity growth and innovation in health care, technology and material science – where Japanese corporations historically excelled versus global peers – not only remain intact, but will accelerate.
It’s a view which is hard to disagree with to a large extent. Abe was Japan’s longest serving prime minister for a reason – he set in motion major changes dictated by his “three arrows” approach of Abenomics, which focused on loose economic policy, fiscal stimulus and economic reform.
That may well be looked upon as something of a golden era, given he assumed leadership of a country burdened by stagnant economic growth. Abe’s only real failure was his inability to reach his 2% inflation target.
The corporate governance achievements are the ones which particularly stand out. If there is one thing the next PM must do it is to continue the focus on improving shareholder behaviours to make Japanese companies more attractive to both domestic and foreign investors.
Other catalysts
There are other emerging catalysts for those investing in Japan to consider. Fidelity Asia Pacific CIO Paris Anand says deflation and weak growth has characterised ‘Japanification’, with stocks being consigned to tactical trades by global investors, but recently Japan has emerged as a beneficiary from economic changes caused by the pandemic.
Anand says Japan stands to emerge as a net winner from shifting global economic conditions in the wake of the pandemic, with growth further invigorated by deep domestic reforms targeting structural challenges. He also feels the region is better positioned than most to prepare for a more inflationary environment – adding that domestic policies targeting capital efficiency, shareholder value and sustainability could bolster investor confidence.
We all know the six to eight bullet points that threaten the economy – in particular that Japan does have huge debt to GDP alongside poor demographics. All of which have contributed to sluggish economic growth.
T Rowe Price Japanese equities fund manager Archibald Ciganer says although the path to Japanese economic recovery is beset with uncertainty, he does believe that a broadening domestic and global economic recovery does mean Japan offers a compelling active management case, particularly as the market “continues to undergo governance reform and improvement, and displays positive change dynamics”.
However, the performance of economies does not dictate the performance of companies. You can make some strong comparisons between Japanese and European equities. Neither have been in investors’ good books for a number of years, but there will always be a plethora of great companies that will be shrouded by that sentiment.
Should the corporate upturn continue in Japan it could be a great opportunity for active managers, particularly at a time when almost every major equity market looks fully valued. Investors may want to consider the likes of the FSSA Japan focus or Axa Framlington Japan funds.
*Source: FE fundinfo, total returns in sterling for MSCI World and Nikkei 225 from 30 December 2020 to 27 September 2021
