Where next for Japan as state of emergency lifts?

Japan has lifted the state of emergency in six prefectures, one week ahead of schedule. Tokyo remains under a state of emergency but this is due to expire on 7 March. The state of emergency came into force in January, as Covid-19 cases rose. Lifting it will allow the authorities in Japan to turn their attention to other pressing issues, including the Tokyo Olympics and the next general election.

We hope it might also allow investors to turn their focus to the earnings recovery being enjoyed by Japanese corporates, and the longer-term improvements in governance and return on equity.

Olympic uncertainty affects political timetable

The Tokyo Olympics were, of course, originally scheduled to take place last year, but were postponed due to the pandemic. Clearly, no-one is now expecting a tourism or spending boom as a result of the Games and we therefore anticipate little economic or market impact from the Olympics whatever the final decision.     

The main impact of the Olympics may actually be on this year’s political timetable, as Japan is due to hold a general election by October 2021 at the latest. The election won’t be held while the Olympics are on, so if the Games do go ahead in July and August, as scheduled, then the election would be held either very soon, in April or May, or would be delayed until very close to the final deadline in September or October.

If the Games are ultimately cancelled, then there would be more options for the timing of the general election. Either way, a decision will have to be made soon regarding the Olympics, not least because of the complex logistical challenge posed by athletes’ travel and quarantine arrangements.

In any event, whenever the general election is held, we expect the ruling Liberal Democratic Party to retain power and Mr Suga is likely to remain as prime minister.

Population still sceptical of pandemic response

The decision on the Olympics is something of a “no-win” situation for the government. Public opinion has largely swung against them taking place, given the ongoing risk posed by the pandemic, but, on the other hand, a cancellation of the games would be a blow to the government’s credibility.  

The Japanese population’s scepticism over the pandemic response has not been helped by a relatively slow start to Covid-19 vaccinations.  This has resulted from existing regulation which requires safety trials to be completed locally in Japan, rather than relying on overseas trials. Nevertheless, final approval was granted for the Pfizer/BioNTech vaccine in mid-February and the initial roll-out for healthcare professionals is now underway.

We expect the pace of vaccinations to pick up rapidly as local authorities have had time to make necessary arrangements and additional vaccines will also gain approval. Japan has ordered more than enough Covid-19 vaccine doses for its population of 126 million.

However, the expected timeframes, plus any unexpected supply issues, will mean that a significant percentage of the population will still be unvaccinated by the summer when the Games are scheduled. Indeed, this will likely be the case even for countries such as the UK which are already more advanced in administering the vaccinations.

The slow start to vaccinations, and the rise in cases that led to the state of emergency being re-imposed in January, mean the population continues to be critical of the government’s handling of the pandemic. However, the pick-up in infections has occurred from a very low base and all the available data suggests that Japan remains in a different league compared to many other developed countries, both in terms of the spread of the virus and the direct economic impact. 

GDP and shares rebound

Japan finished 2020 with GDP growth of 3% (quarter-on-quarter) in the final three months of the year. This was well ahead of expectations and brought Q4 GDP up to 98.9% of the pre-pandemic level seen in Q4 2019. Although there is likely to be a negative impact from the state of emergency in the current quarter, Japan’s economic performance compares favourably with other developed nations.

Japanese shares have responded positively to the growing economic momentum and the start of the global vaccine roll-out. We have also seen strong evidence of the rebound in activity from the latest corporate earnings season.

A typical quarterly earnings season in Japan would see one-third of companies beat market expectations, one-third miss, and one-third report in-line results. For the October to December quarter, we estimate around 65% - nearly two-thirds - beat expectations, with the rest largely in line. Very few missed forecasts.

We should acknowledge of course that market expectations were relatively low due to the pandemic but the results do point to activity picking up and there are some areas where results have been genuinely strong. The automotive sector is one such example, which has had a positive impact throughout the supply chain.

Structural improvements still to come

So, the question now is whether all the good news for Japan is already priced into shares.

Japan’s shallower economic downturn during 2020 now means that the scope for a domestic recovery in 2021 and beyond appears less dramatic than predicted for some harder-hit economies. However, Japan is well placed to benefit from the broader global recovery which is yet to fully take hold.

Perhaps more importantly, we see a number of structural shifts that can support Japanese shares in the longer term, and crucially, help businesses to improve their return on equity. (RoE is a profitability measure that reveals how much profit a company earned in comparison to the shareholders’ capital retained in the business. A higher RoE typically translates into higher returns for investors.)

Firstly, we think Japanese firms are slowly but surely improving their corporate governance. Japan has long been criticised for relatively weak corporate governance that has allowed poor capital allocation to persist within companies. However, we can identify numerous companies across different industries who are taking steps to deal with underperforming parts of their operations. This is a key step to improving RoE.

Secondly, company management is putting more focus on shareholder returns. The chart below shows that Japanese firms have been relatively successful in maintaining dividends even during last year’s turmoil, and we see signs already that share buybacks are returning to normal levels. This is primarily due to the strong financial position of many Japanese companies. (Share buybacks are when a company acquires its own shares, as a flexible way of returning money to shareholders).


Thirdly, Japanese firms overall are in a solid financial position that should help enable them to invest in productivity improvements. Companies’ intention to invest in IT and software, as tracked by the Bank of Japan, continues to rise and we believe this is a key element in driving future productivity gains.

We expect these three factors to drive an improvement in RoE overall but, as ever, identifying the specific stock opportunities is crucial. We continue to favour those companies where we can see realistic scope for improvement driven by company-specific actions, rather than relying on broader macro factors, or a simple cyclical recovery.