The case for and against Japan

The British novelist L.P. Hartley once wrote that “The past is a foreign country, they do things differently there,” and for many advisers and clients, Japan is one of the most alien options available from an asset allocation perspective, easily dismissed as a debt-and-deflation riddled basket case, beset by ineffective politicians, poor corporate governance and a central bank that seems determined to interfere in vital market mechanisms.

And yet Japan, as benchmarked by the Nikkei 225 index, has quietly been the second-best performer out of eight available major equity market options, in sterling, total-return terms, since Shinzō Abe became Prime Minister for a second time in December 2012 and immediately launched his ‘Three Arrows’ programme.

Japan has performed strongly under ‘Abenomics’

Source: Thomson Reuters Datastream, since Shinzo Abe became Prime Minister on 26 December 2012

The combination of fiscal stimulus, accommodative monetary policy (with the help of the Bank of Japan) and social and corporate reform does look to have boosted equity returns from the Tokyo market. The question that advisers and clients must address now is whether this can continue or not?

The case against Japan

The ‘Three Arrows’ may be hitting the target but sceptics will still argue Japan is still far from a sound asset allocation option, even nearly 29 years after the bursting of a debt-fuelled equity and property market bubble that peaked in 1989, for three reasons.

  • Debt. Hampered by poor demographics, in the form of an ageing population, and the legacy of previous, failed attempts to spend its way out of trouble and into growth Japan is saddled with huge debts. Government debt to GDP is 232% of GDP according to the Bank of Japan (BoJ).

That is the highest figure in the world and one that leaves the Abe administration with less ammunition than it would like. An increase in consumption tax from 8% to 10% is planned for October 2019, to try and put some cash in the kitty, but this has already been delayed for three years and with good reason, since 2014’s increase from 5% to 8% pushed the country into recession.

  • Growth and inflation. Both remain tepid, despite the Abe administrations’ efforts. The economy shrank quarter-on-quarter in Q1 of this year, the first decline in nine quarters. Although some have blamed a harsh winter for that dip, the weather cannot be blamed for the Bank of Japan’s clear failure to drive inflation toward its 2% target, even if wage growth has just reached a two-decade high of some 1.3%. Governor Kuroda has even stopped giving a timescale for its inflation goal to be reached, in what could be seen as a tacit admission of failure.

Inflation has failed to catch fire despite ‘Abenomics…’

Source: Thomson Reuters Datastream

In addition, corporate confidence, as measured by the Tankan survey, has begun to dip again. This matters as the Nikkei 225 stock index does seem to draw inspiration from the quarterly Tankan.

Advisers and clients need to watch the Tankan corporate confidence survey

Source: Bank of Japan, Thomson Reuters Datastream

  • Politics. Financial markets still seem to be in thrall to Prime Minister Abe but Japanese voters seem less enamoured. A series of graft scandals have seen the Cabinet’s approval rating drop to the lowest level seen during the Abe administration that began in 2012, according to data from Japan Macro Advisers. Abe won a third straight general election in December 2017 and he seems primed for a run toward the 2021 ballot but nothing can be taken for granted given the generally short lifespan afforded to leaders of the Liberal Democratic Party. Were Abe to unexpectedly fall from office markets could take fright, at least temporarily.

The case for Japan

  • The Bank of Japan. The Bank of Japan is holding interest rates at -0.1% and showing no sign of either raising them or backing away from its ¥80 trillion a year Qualitative and Quantitative Easing (QQE) programme, which it is using to buy government bonds, to force down their yield, and also purchase Exchange-Traded Funds (ETFs) that track Japanese stocks. Low returns on cash and bonds could force investors toward equities, as has happened in the UK, US and Europe, especially as they met get to ride a tidal wave of BoJ cash there, too.

The Bank of Japan continues to run an ultra-loose monetary policy

Source: Thomson Reuters Datastream

  • Corporate reform. Encouraged by the creation of the JPX-Nikkei 400 index, which includes firms on the base of profits and governance not size, Japanese corporates are raising their game. Dividends and share buybacks are on the up while research from Japan Macro Advisers shows that return on equity (ROE) amongst Japanese corporates is rising as profit margins expand. ROE now exceeds the 8% goal laid out by a 2014 Government paper.
  • Valuation. Japan’s stock market is not trading at or very near to its all-time highs, unlike say the UK or USA. In fact, at around the 22,800 mark the Nikkei 225 index trades more than 40% below the peak it reached all the way back in December 1989.

Japan’s Nikkei 225 still trades way below its 1989 peak

Source: Thomson Reuters Datastream

As a result, Japan looks relatively cheap compared to other major markets, on an earnings basis, especially as profits are nowhere near past peaks, in contrast to the USA and UK. Japan looks cheaper still on 1.3 times book (or net asset) value, according to research from M&G, especially as a lot of the assets are simply cash.

Japan’s Nikkei 225 still trades way below its 1989 peak

Source: Société Générale research

Test case

One thing is certain. After more than two decades of interest rates below 1.00%, multiple fiscal stimulus programmes and over a dozen rounds of QE since the early 1990s, Japan is the model that no western central banker wishes to emulate – and as such the Abe and Kuroda regime remains a key test case, as the European Central Bank and Bank of England continue to run ultra-loose monetary policy and the US Federal Reserve continues to tighten at a very steady pace.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.