For most of the past 18 months or so, coinciding with the start of the administration of Prime Minister Shinzo Abe, Japan experienced a strong cyclical upswing in its economy. And despite some potential challenges, such as the new consumption tax hike, there are signs that may indicate a re-emergence of growth. What does that mean for investors? Get insight from our experts in a Fidelity Investments roundtable, moderated by Timothy Cohen, Fidelity’s chief investment officer of international equities.
[Note: The following is an excerpt of the commentary provided during the late June 2014 roundtable discussion. Views represent those of one or more individuals, and should not be considered as the collective view of either Fidelity Investments or any particular investment division.]
Tim Cohen: Many fear the April 2014 increase in the consumption tax from 5% to 8% will halt the nation’s momentum. How could it impact Japan’s growth prospects?
Lisa Emsbo-Mattingly (director, Asset Allocation Research): The April consumption tax (CT) hike from 5% to 8% presents a risk not just to Japan, but to the rest of Asia. In 1997, the last time Japan raised the CT, consumer spending rose in the months preceding the tax, then collapsed and helped send Japan into recession after the tax went into effect (see chart, below). While a downturn in consumption during Q2 will not be a surprise, there is a risk that this event may not only short-circuit the momentum of Japan’s household sector, but also cause a bigger demand shock that resonates across Asia and its major trading partners, particularly if the CT saps the confidence of the Japanese consumer, who represents approximately 60% of Japan’s GDP.
Kirk Neureiter (portfolio manager, Fidelity Japan Fund): Interestingly, though, the most recent data point on retail spending through May—this is for all retailers in Japan—reveals that the year-over-year number is actually flat. This, to me, is incredible considering the drop-off that was expected following the introduction of the consumption tax. So private demand seems to be holding up better than maybe a lot of people expected.
Camille Carlstrom (associate portfolio manager, Pyramis Japan Growth Strategy): Anecdotally speaking, few companies, if any, have reported to us that business conditions are worse than expected. In fact, one of our analysts just returned from a trip to Japan where he met with a number of health care and materials companies, and the materials companies that supply to the automotive industry are optimistic on performance in the second quarter due to a less-than-expected decline in spending.
Cohen: What is Japan doing to address its deflationary economy and counteract the negative effects of the consumption tax?
Emsbo-Mattingly: The objective of the Abe administration and the Bank of Japan (BOJ) is to resuscitate inflation. From an asset allocation standpoint, it’s very important to realize that the BOJ has always been a key player, but the policy it has implemented—this massive increase in the willingness to buy and willingness to stabilize the Japanese government bond (JGB) market—is a very big change that we’ve seen over the past 18 months. And it’s something to watch. You can see a big divergence in the trajectory of Japanese government bond yields (at all-time lows) vs. U.S. government bond yields during the past year, when traditionally they have tended to move in a more correlated fashion (see chart, right).
Neureiter: So on that point, the BOJ’s goal was to almost triple the country’s monetary base by the end of 2014. The purpose of this goal was to stimulate the economy, increase the velocity of money, weaken the yen, and keep interest rates low.
Emsbo-Mattingly: Right. And so that may be beneficial to the Japanese exporters and the stocks of Japanese exporters, but it’s not particularly good for the domestic economy in Japan, which, as stated earlier, is about 60% of GDP.
Carlstrom: But let’s also keep in mind that a number of moves the Abe administration has announced have either just been enacted or won’t be enacted until later this year. For instance, it has put through several programs to encourage corporate capital expenditures, and they all started in April. Other policies put forth by Abe, which are designed to boost infrastructure and increase public spending, take effect in the second half of this year. Abe has also been talking about the potential for a corporate tax cut, which could boost Japan’s GDP growth and, by extension, corporate earnings growth. Japan has already turned from deflation to inflation, even without the consumption tax and even without the food and energy inflation, which has been significant. Its Consumer Price Index (CPI), less food and energy, is now indeed positive.1 An important thing to watch is if the government starts to quote CPI with the consumption tax impact in there. That would be a very negative sign that things in Japan have gone awry, because their goal for 2% inflation is without the consumption tax impact.
Neureiter: The government and BOJ are also telling companies to deploy their cash, or it will eventually get inflated away if it’s just sitting on their balance sheet. Corporations are trying to deploy that cash faster than they have in the past, which should portend well for capital spending and other growth opportunities. Until November of this year, I don’t think we will see additional purchases by BOJ beyond what they’ve announced so far. But I would expect this current purchasing trend to continue into 2015, so they will continue to be very accommodative.
Cohen: How has the yen responded to the government’s anti-deflation policies, and what has been the impact on Japanese exports?
Emsbo-Mattingly: The yen has weakened substantially over the past 18 months, and that should be a net positive for Japan and for Japan exports. But, at the same time, it is a competitive shock for the rest of their trading partners. I think the yen is undervalued versus the U.S. dollar and also relative to many other currencies, and we think that’s actually putting pressure on Asian economies to devalue their currency. We’re already seeing the tiny beginning of a weaker Chinese renminbi (RMB), and if we see a sustained weakening of the RMB over the next few months, that’s telling you there is stress in Asia. And for whatever reason, Japanese exports have not really benefited from that weak yen. In fact, nearly all export indicators, whether they’re from China, the U.S., or Europe, have been weak.
Carlstrom: Japan’s exports are indeed a negative. But one thing we need to think about is that a lot of Japanese companies are now producing overseas. And so that production is not going to go into GDP growth, but it is going to go into corporate profitability, which is where we’re investing, on increased profitability. And business sentiment is turning positive. For the first time in 22 years, non-manufacturer sentiment has turned positive and, importantly, manufacturers and small and medium-sized enterprises (SMEs) were positive for the first time in six years.
Cohen: How have these factors affected Japan’s employment market?
Emsbo-Mattingly: Japan’s job market is white hot. However, real income—real total gross cash earnings—have turned negative, while nominal income growth is at zero. We have not been seeing broad-based, sustained increases in wages, because the productivity rate of the overall economy has not been improving. If the government’s structural reforms and productivity start rising in a broad-based way in Japan, then I think you might get sustained real gains in income. But seeing real earnings go into negative territory in Japan has traditionally been a very negative sign.
Carlstrom: As Lisa pointed out, the labor market is tightening. Japan’s unemployment rate, which was around 5.5% in 2009, is now down to about 3.5% (see chart, right). But as far as wages go, I wonder: Could real cash earnings be down because of the considerable number of people in Japan who are retiring? The wage differential between the older worker versus the newer worker in Japan is dramatic, so as higher earners exit the workforce and are replaced by younger workers at lower wage levels, wouldn’t that put downward pressure on wage data? Even just the fact that the labor pool is shrinking would exert some downward pressure.
Cohen: What about consumer confidence? What is it telling us?
Emsbo-Mattingly: Consumer confidence is still down considerably from where it stood a year ago, though it did jump higher in May off its April low (see chart, right). However, we saw this happen in 1997 as well. In 1997, consumer spending bounced off its bottom of April and into May, but then turned back down again and was followed by a recession that lasted nearly two years. Could this happen again in 2014? It’s possible. Our internal recession probability model shows Japan right on the threshold of recession, particularly as it enters the late cycle phase of its business cycle. Only 50% of leading indicators in Japan were positive through the end of April, compared with 90% about a year ago.
COHEN: Where do you see potential opportunities in the Japanese stock market?
Carlstrom: Our investment team is focused more on secular versus cyclical growth stories, as we were in the past. Some of the themes we like include the “electrification” of cars. This is a very big deal for auto suppliers in Japan. In addition, for the first time in a long time, we are overweight in big pharmaceutical companies. Before, we had done very well with health care equipment, but now we see some great opportunities in blockbuster drugs. I’d identify energy savings as a third theme. Energy costs in Japan are enormous, and companies that can help cut those costs may be attractive takeover targets.
Neureiter: Energy is a theme in our portfolio as well, and has been the best performing sector year to date. Tobacco and e-commerce are other areas of focus, along with Japanese rail companies. Broadly speaking, I try to find and invest in companies that are poised to improve their return on equity over the next two to three years.
David Jenkins (portfolio manager, Fidelity Japan Smaller Companies Fund): I’m definitely geared toward the smaller names. I look for the nexus between low valuation and high quality, plus strong shareholder remuneration. Some examples of good ideas I am finding are manufacturers of karaoke equipment and content. Another is geared toward services for buildings, such as cleaning, security, and maintenance. These businesses tend to have high recurring revenues and good returns on capital.
- Stay up to date on news and markets in Japan.
- Kirk Neureiter manages Fidelity Japan Fund (FJPNX).
- David Jenkins manages Fidelity Japan Smaller Companies Fund (FJSCX).
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