Short-term negativity in Japan looks overdone
The recent pullback in Japanese equities has reduced valuations at a time when we believe the long-term picture for corporate Japan may be gradually improving.
19 April 2016
In recent weeks investors’ sentiment towards Japanese equities has become very negative. This seems particularly true among foreign investors who have been significant net sellers of the equity market this year.
However, it is important to disentangle this sentiment impact from the actual economic and corporate data and focus on whether our own expectations need to change as a result.
It is definitely the case that some of the recent economic data from Japan has undershot expectations, which has led some commentators to brand both “Abenomics” and the Bank of Japan’s monetary policy as failures. But we think it is far too early to draw this conclusion.
In particular, the Bank of Japan’s move to negative interest rates has not yet had any chance to impact on the real economy. Within the last week, views have been further clouded by a sequence of large earthquakes in Kyushu.
Although we recognise the human tragedy involved in these events, this is unlikely in itself to have any significant macroeconomic impact and the initial reaction in stock prices in insurance and auto stocks, for example, has been out of all proportion to any eventual profit impact.
Positive trends in place
Behind these short-term developments, most of the positive trends remain in place. Although all measures of inflation remain well below the central bank’s 2% target, it is nevertheless true that Japan seems to be in the process of a sustainable exit from a long period of deflation.
However, with no developed economies currently running inflation of 2%, it is arguable that the fault lies with the target in Japan, not the policy.
We must also bear in mind the impact of the oil price decline in the last 18 months which is exerting a strong downward pressure on inflation in Japan.
On the positive side, the labour market in Japan continues to tighten, with the unemployment rate declining and the number of job offers to applications rising sharply.
One particular area of concern for investors at present is the outlook for corporate profits and capital expenditure. Japanese companies will shortly begin announcing their results for the fiscal year which has just ended.
In this regard, the rapid strengthening of the currency in the last two months has created additional uncertainty and is likely to lead to companies being overly conservative in their own forecasts for profits for the fiscal year to March 2017.
Thereafter, in the absence of additional external shocks, we could expect to move back into a positive revision cycle later this year.
We have also seen disappointingly weak expectations for capital spending reported in the most recent Tankan survey but it is worth bearing in mind that Japanese companies are historically very poor at predicting their own capital expenditure.
With most companies holding high levels of cash on their balance sheet and labour becoming scarce, we see a good chance that this year’s initial forecast of capital expenditure will again be beaten.
Policy measures to be supportive
The strengthening of the yen has been a totally unexpected consequence of the Bank of Japan’s move to negative interest rates as it runs counter to the actual change in interest rate differentials.
In this respect it is again important to focus on the real change in the longer-term fundamental which is that the Bank of Japan’s monetary policy is extremely accommodating and likely to become even looser in future.
Over the next few months there will also be an intensifying debate over the implementation of the next rise in consumption tax, currently scheduled for 2017.
Although Prime Minister Abe has not yet announced any decision to postpone, such a move is becoming increasingly likely.
In the run-up to July’s Upper House elections we should also see a significant fiscal stimulus package announced to run alongside the Bank of Japan’s easing policy.
However, with the labour market already tight, and construction companies in particular struggling with labour shortages, it may be harder than usual for the government to find a route by which its spending programmes can have a meaningful impact on the real economy.
Overall, however, we should expect that the combination of fiscal and monetary policy will be supportive of the equity market.
Corporate governance on the up
Lastly, and largely unrelated to other economic factors, we should consider the improvements underway in corporate governance in Japan which is an area of clear success for the Abe administration.
The long-term trends towards more independent directors is unquestionably positive and we already find more productive levels of engagement with many companies as a result of their improved focus on shareholders.
While it is perhaps hard yet to see an immediate connection of this with share price performance, these same trends are also behind the increase dividend pay-outs and record levels of share buybacks which are having a demonstrable impact on share prices.
Potentially brighter road ahead
As a result, the recent pullback in the market has reduced valuations at a time when we believe the long term picture for corporate Japan may be gradually improving.
While we recognise the scope for further short-term volatility as we enter the corporate results period over the next few weeks, we feel this could set the stage for sustainable positive returns from Japanese equities as evidence of stronger profit performance is further supplemented by additional policy support.
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