Japanese inflation has been at or near zero since the 1980s. In December, it rose to a fresh high of 4%. In the context of UK inflation at over 10%, this may look like stable prices, but for Japan, it represents a significant departure. It is causing ructions in the Central Bank of Japan and may have implications for investors in the region.
Last year was tough for investors in Japan. A significant slide in the yen – which was down 30% versus the dollar and 10% versus the pound at its weakest point – dented returns for international investors even though the market proved relatively resilient in yen terms. The average Japan fund was down 8.1% for the calendar year 2022, which put it in line with Europe ex UK or Global Corporate bonds.
The yen weakness finally prompted the central bank to take action and intervene in the last few months of the year. In December, it surprised the market by lifting its cap on 10-year government-bond yields from 0.25% to 0.5%. This is its biggest shift since 2003 and saw the currency surge. With inflation now at a 41-year high, the central bank remains under pressure to lift rates further.
While 4% inflation looks low relative to the rest of the world, Nicholas Weindling, manager on the JPMorgan Japanese trust, says it marks a change for the country: “Deflation has become so entrenched in Japan, so the authorities have really wanted to engineer a little bit of inflation. Even a little bit is a big difference. There had been no significant wage demands, in spite of the fact that wages were largely unchanged in 30 years. But then there is no inflation – so why do wages need to rise? One of the big things that’s happening today is that we’re starting to see a little bit of wage inflation.”
The most notable example of this was Uniqlo owner Fast Retailing, which recently announced that it would raise employee wages by as much as 40% in a bid to help them cope with rising prices. Others looks set to follow suit – Suntory Holdings, the drinks group behind Jim Beam and Yamazaki, says it will raise wages by 6%. This could finally create the virtuous circle of rising wages, improving consumption and prices that Japanese policymakers have been trying to engineer for decades.
The reversal in the currency has given investors a significant tailwind in the early weeks of 2023. However, this – along with a shift in the country’s long-established pattern of deflation – may not be enough of itself to tempt investors back to Japan. Japan has slipped off investors’ radar, becoming progressively less relevant – investors have grown used to the outperformance of the US and Japan is now a smaller part of the MSCI World index.
However, there are other reasons to reconsider Japan. Weindling says that the weakness in the yen has masked a relatively robust outlook for Japanese corporate earnings. He points out that Japan is only just reopening after Covid-19 and therefore has its recovery ahead, particularly in areas such as tourism. Rising wages may encourage consumer spending at the same time, creating stronger tailwinds for companies. Unblocking supply chains may also be advantage, with some Japanese companies having struggled with a shortage of components.
There is also a valuation argument for Japan. Joe Bauernfreund, fund manager on the AVI Japan Opportunity Trust, says Japan stacks up attractively on valuation. At the end of December, the MSCI Japan traded on a forward price to earnings ratio of just 12x, compared to 15x for the MSCI World. Its price to book value was just 1.2x, compared to 2.7x for the MSCI World. A weaker dollar seems increasingly likely in the year ahead and this may lure investors away from US markets; Japan looks like an obvious beneficiary.
The other consideration is corporate governance. Bauernfreund says that progress is slow, but dividends and share buybacks are improving. There are more independent directors. He adds: “Company management has bought into that revolution.” Cash levels are still high, but this may be a help rather than a hindrance as the world enters a recessionary environment.
There remain sceptics on Japan. Murray International, for example, continues to have a zero weighting in Japan, having sold out of Japan Tobacco. Its managers say they can’t get comfortable with capital allocation by Japanese corporates. Some asset allocators remain sceptical that business leaders can really reshape the region’s sclerotic corporate culture.
Others are worried that a rising yen may dent the dominant export sector. What investors gain in currency appreciation, they may lose in earnings weakness. However, this may be no more true for Japan than for any other market. Bauernfreund says: “The exporters are not as dominant today. Even the large car manufacturers are not as export-focused as they were. The argument ‘markets won’t rise because of the yen’ is flawed – there are plenty of beneficiaries of the strong currency too.”
The MSCI Japan index is now at the same level it was in 2017. Japan may have its flaws, but this seems extreme. From valuation, to reform, to an improving macroeconomic picture, there are reasons to look again at Japan in the year ahead.
