Japan’s Nikkei just recorded a 16-day winning streak, its longest on record. When thinking about Japan, many who started following markets closely in the late 1980s know nothing but year after year of recession, deflation, and a poorly performing stock market. It has been a long, slow process; but, we believe that investing conditions are changing in Japan for the better, making the country’s markets worth a look.
Economic growth has been improving with six straight quarters of real gross domestic product (GDP) growth, the most since 2005-2006. That period included a quarter that was essentially flat, so you must go back to the mid-1990s to find six straight quarters with meaningful growth. A potential 1.5% increase in GDP in 2017 (based on Bloomberg consensus forecasts) does not sound like much, but it is the fastest rate of growth since 2013. And for an economy – the world’s third largest – that has been regularly in and out of recession for three decades, it represents progress.
It is also making progress against deflation. Wages have started to pick up, albeit gradually, putting some upward pressure on interest rates. Although low unemployment in Japan is not newsworthy, the quality of jobs is improving. Additional structural reforms could help an already improving picture.
Prime Minister Shinzo Abe has consolidated power with his recent election victory in which his ruling coalition retained its two thirds parliamentary majority, providing a continuing mandate for his “three arrows” plan: government spending, monetary policy, and structural reforms.
The first arrow, government spending, is limited by Japan’s already heavy debt load. Opposition to more government spending appeared after a proposed sales tax to pay down debt met with resistance. The second arrow, however, is firing on all cylinders. The Bank of Japan (BOJ) is expected to continue its aggressive securities purchases. The BOJ is also expected to continue capping interest rates at zero to support bank lending and encourage investor risk taking, even as the U.S. and Europe pull back support. This divergence in monetary policy may help keep the value of the yen down, which may help Japanese stocks. Historically, a weak yen against the dollar has meant that Japanese stocks outperform their U.S. counterparts. A weak yen helps support exports, critical to the county’s growth prospects. Japanese exports rose 13% year over year in August, the latest reported month. We consider currency hedged Japanese equity exposure preferred to unhedged.
The structural reform arrow is still a work in progress. Deregulation, immigration reform, and encouraging women in the workforce are among some of the policies that can help offset the demographic headwinds of an aging population. A stronger military isalso a part of Abe’s platform, so we could see more defense spending.
For many years, one of the knocks on Japanese stocks was that the companies were not managed for the shareholders. The corporate culture in Japan has been changing, with smarter capital allocation decisions and more cash returned to shareholders in the form of dividends and buybacks.
Since 2006, dividends for the MSCI Japan Index have grown more than 75%, or 5.9% a year – not far behind the U.S. equivalent (7.5%). Growth in share buybacks has been even stronger, increasing by more than 150% over the past 10 years, or 9.8% a year, more than five times the growth rate of buybacks for the S&P 500 Index.
Greater focus on return on equity (ROE), a measure of profitability, is another positive development in corporate Japan. Stock valuations and ROE are connected, so companies with large cash hordes and depressed ROEs – like many in Japan – have tended to be penalized with lower valuations. A greater focus on ROE is an incentive for companies to put cash on their balance sheets to productive use, potentially supporting higher equity values.
Despite better corporate governance, returning more capital to shareholders, and higher ROE, the Japanese stock market is cheaper than the U.S. and European stock markets. On a forward price-to earnings ratio (PE) basis, Japan is 14.2 compared with 17.9 in the U.S. and 15.1 for Europe even with comparable expected earnings growth. Consensus earnings estimates are calling for 18% earnings growth for 2017 and 7% in 2018.
The lack of relative optimism toward the Japanese equity market may indicate an opportunity. According to the latest data on investor positioning, U.S. investors are underweight Japan. In fact, the recent Baron’s Big Money poll, a survey of 140 money managers across the country, showed that only 6% expect Japan to be the top performing market over the next 12 months, the lowest of the five choices (emerging markets, Europe, U.S. China, and Japan). When there are few bulls, the opportunity exists for more to emerge and push stocks higher.
We think the Japanese stock market is worth a look. Prime Minister Abe has a mandate for continued policy stimulus and structural reforms. Corporate Japan is acting more in the interests of shareholders. And valuations are attractive. Of course, the North Korean threat remains an obvious concern, demographic challenges are significant, and the country’s latest resurgence could be another in a long history of head fakes. But all in all, there are enough positives for investors to consider Japan, particularly if they are concerned about elevated valuations in the U.S.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- All indexes are unmanaged and cannot be invested into directly.
- Unmanaged index returns do not reflect fees, expenses, or sales charges.
- International investing involves special risks including the fluctuation of dividend, loss of principal, and potential liquidity of the investment in a falling market.
- Data provided by LPL Financial, Bloomberg and Barron’s.
- All investing involves risk including loss of principal.
- Past performance is no guarantee of future performance.