After two "lost decades," the Nikkei’s surge of more than 50% since mid-November 2012 has caught the attention of investors. They may be wondering whether Japanese equities are finally pulling out of a nearly 25-year bear market. Or is this rapid move in the equity market simply a flash in the pan brought about by the sharp 20 percent depreciation in the yen?
My answer is that despite the currency change, we may continue to see investment opportunities in Japanese equities driven by a sea change in the economic and political backdrop. Beyond the yen weakness, which has captured most of the headlines and helped to make the corporate sector even more competitive, the policies put forward by the new Liberal Democratic Party (LDP) administration will, in my view, be vital to sustaining the upward move in equities.
New LDP economic policy initiatives encourage optimism.
Since replacing the Democratic Party of Japan (DPJ) last December, the administration of LDP Prime Minister Shinzo Abe has announced a slate of measures designed to ignite an economic recovery and pull Japan out of its deflationary spiral.
Until very recently, there was abundant disbelief that these policies would be effective if they were implemented. However, when Japan is attempting to climb out from such a large economic policy void, the magnitude of change doesn't have to be extreme to have a healthy impact on the economy and the equity market.
In the upcoming months, the government will introduce a variety of legislative initiatives. If these policies are successful, 2014 nominal GDP growth could be above growth in Europe and the U.S., which would likely spur continued outperformance in Japanese equities versus other developed markets. The "three arrows" of Abe’s plan for economic stimulus are monetary policy, fiscal policy, and structural growth strategies (see the chart right).
Steps toward the implementation of bold monetary policy and flexible fiscal policy—two of these arrows—have already been taken. And there could be movement on growth strategies—the third arrow—after the Upper House election in July or August.
Given the LDP's high approval rating, Abe’s party is likely to win the election and gain control of both houses. This should remove further barriers to the growth strategy arrow, which is important to the market because it is not only pro-economic growth, but also pro-business. I expect these efforts to enhance corporate value, and changes in earnings power should continue to support the equity market.
Strong yen prompted restructuring
Before the recent weakness in the yen, the currency had experienced a multiyear strengthening trend. The yen appreciated against the U.S. dollar at an annualized rate of 4.7 percent during the five years through the end of 2012 (see the chart right).
In the short time since then, however, the yen has fallen dramatically relative to most major currencies. Given that this rapid depreciation has coincided with strong equity market performance, the weak yen has been portrayed as the only good thing happening for corporate earnings in Japan.
There is reason to disagree with this premise. While the weak yen may finally allow Japanese companies some breathing room to grow, the strong yen was probably one of the best things for Japan’s corporate sector.
In recent years, as Japanese companies have struggled with a very strong yen, many have striven to restructure in order to remain competitive. Businesses have streamlined purchasing operations, shifted to lower-cost production bases overseas, consolidated inefficient industries, and sold underutilized or unprofitable assets.
The increased efficiency of Japanese corporations is demonstrated by the decline in the breakeven level of the yen at which businesses can profitably export, with the translation effects alone resulting in ample upside to profitability (see the chart right).
Having brought about this shift in cost structure, the weak yen now increases Japanese competitiveness disproportionately. Companies in other countries who have benefited from the strong yen tailwind in recent years may be less able to compete on price and feel their profits come under pressure. This dynamic may allow Japanese companies to gain market share versus their global competitors, which would provide additional support to corporate profits.
Obstacles remain to be tackled
For years, many observers have pointed to the structural obstacles impeding Japan's economy and, by extension, the equity market. Aging demographics, the soaring debt-to-GDP ratio, ongoing deflation, and a stagnant corporate sector are among the most frequently cited.
Such structural issues will not be solved overnight, but I think that a new government with clear and positive policy initiatives can help. Here are some ways that could happen:
- With regard to the headwind of aging demographics, the LDP's conservatism on immigration policy makes it unlikely to break much new ground to boost the working-age population. However, labor deregulation could allow for a more fluid workforce, including the possibility to redeploy labor quickly when necessary and to make better use of certain groups, such as women and younger retirees. For example, child care reform is on the agenda, and the official retirement age is slowly rising.
- The high debt-to-GDP ratio has been the focus of investment bears, but the country could avoid falling into a classic debt trap. The government's broad asset base—both on- and off-balance sheet—has the potential to serve as a "fourth arrow" to restructure, and thus, mitigate Japan’s debt burden.
- Reversing chronic deflation is a main goal for fiscal and monetary policy. Even if the two percent inflation target is not hit in two years as planned, these policies may make significant strides toward that goal.
- The historical stereotype of a stagnant corporate sector is beginning to change as Japanese companies have tackled the problems of deflation, a strong yen, and the financial crisis. Ardent Japan watchers have been aware of this for years, but the markets are only now starting to recognize the transformation.
To overcome these and other obstacles to economic growth, a number of policy levers could still be pulled in Japan, and the LDP government has just begun to pull them. If the Abe administration can successfully implement many of the policies it has been exploring, these issues could fade in importance—and a bull market in Japanese equities may come into sharper relief.
After the robust rally in Japan's stock market, investors may be wondering what could be next. The Japanese have spent more than two decades in economic and equity market malaise following the excess of the asset bubble of the late 1980s.
I believe that this may not be just another bear market rally along the lines of 1993, 1999, and 2003, but the beginning of a new era for Japan. Asset prices, including real estate, have normalized. Stock market valuations, which peaked at very high levels, have corrected. Japanese corporations, with excessive cost bases, have restructured. Around the world—from the retail investor in Japan to the global investor in San Francisco—equity investors appear to be generally underweight Japan.
While we have already seen a handsome rise in Japanese stocks in the past few months, I argue that the positive changes in Japanese politics and their effects on the equity market have just begun.
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