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Making the case: Active allocation to Japanese equities

Making the case: Active allocation to Japanese equities

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1 Abenomics is the economic policy embracing fiscal and monetary stimulus unveiled in 2013 by Shinzo Abe, Japan’s prime minister.2 Source: Russell/Nomura, accessed as at 31 January 2018.

I. A positive macro backdropEconomic growth has seen Japan go from zero to hero in recent years. Most notably, nominal GDP growth YoY has now been positive for 21 consecutive quarters.

For Kashima, this spurt of growth is a major milestone. After many years in the doldrums, nominal GDP is above ¥533 trillion, meaning the economy has finally recovered the ground lost over two long decades of decline.

“GDP has recovered very nicely since start of Abenomics1, and at last we’re back to the level of 1997 when deflation started,” she says. “Even so, we still have a long way to go before we reach the government’s nominal GDP target of ¥600 trillion so there’s no reason for a change in direction just yet.

“If you step back and look at what the government promised on the economy and what it’s actually achieved, it’s pretty impressive. We think it points the way to a positive outlook for investors.”

NOMINAL GDP GROWTH YOY HAS BEEN POSITIVE FOR 20 CONSECUTIVE QUARTERS

450

475

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575

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2025

2023

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2019

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-10-505101520253035404550

YoY (RHS) Nominal GDP (LHS)

Abenomics starts in 2012

Recovered to1997 level

GovernmentTarget

600 TrillionYen

Trill

ion

JPY

2. Less dependent on exports than you’d expect…Investors might be forgiven for wondering whether the current global trade war narrative could dent Japan’s positive growth story. But the traditional image of the Japanese economy being dominated by exporting industries doesn’t really stand up to closer scrutiny, says Kashima.

Consider figures from the Russell Nomura Index. The aggregate export ratio of the Russell Nomura Index companies is around 34% based on sales.2 Similarly, World Bank data suggests Japan’s export ration as a proportion of GDP is below that of fellow G7 members the UK, France, Canada and Germany.

“Even now,” says Kashima, “the Japanese equity story for international investors has mostly been about large, export-orientated companies and has essentially been a play on the global recovery. But we argue for a different approach. It’s easy for international investors to overlook, but Japan has a vibrant domestic economy of its own and the companies that do well there can often do so without too much reference to what’s going on in the wider world.”

JAPAN’S RELATIVELY LOW DEPENDENCE ON EXPORTSExports as a percentage of GDP

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50%

60%

70%

80%Asia

Exp

orts

in %

of G

DP

Exp

orts

in %

of G

DP

Developed Countries

Thai

land

Mal

aysi

a

Kor

eaP

hilip

pine

s

Chi

naIn

dia

Indo

nesi

a

Ja

pan

Switz

erla

ndG

erm

any

Spa

inC

anad

aFr

anceUK

Aust

ralia

Japa

nU

SA

Source: The World Bank, Bloomberg. Data for Japan, US and Switzerland are as of end of 2015. All other countries are as of end of 2016. Most recent data available.

Miyuki leads the Japanese Equity Team based in Tokyo and is ultimately responsible for all strategies run by the team. Miyuki started her career at Morgan Grenfell (Renamed Deutsche Asset Management) as a Japan equity analyst in 1985. She became a fund manager in 1987 and has focused exclusively on Japanese equities. From 1997 she was the Head of Japanese equities at Chase Trust Bank and moved to Merrill Lynch Investment Managers (Renamed BlackRock) in 2000. She then moved to ING Mutual Funds in June 2009 where she was responsible for managing the process and performance of the Japanese equity team and also helped to enhance the investment process of other products in the Asia Pacific region.

As it continues to bounce back from a prolonged period of contraction, the Japanese economy offers an attractive opportunity set to investors, says Miyuki Kashima, Head of Japanese Equities, BNY Mellon Asset Management Japan Limited.

Source: Economic and Social Research Institute, Cabinet Office, Government of Japan, e = government estimate as of 30 June 2019. Latest available data as of June 2019. For illustrative purposes only. Nominal GDP is a nominal seasonally adjusted quarterly GDP.

Making the case: Active allocation to Japanese equities

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3. Abe will be longest all time PM in historyFor a further reason to be positive on Japan, consider the question of political stability. Japan has gone from being a something of a political basket-case in the mid-2000s to an exemplar of stability today. Between 2006 and 2012, the country had no less than seven prime ministers; more than one a year. That all changed following the election of Shinzo Abe as prime minister in December 2012.

Since then Abe’s LDP party has remained in power, maintaining its two-thirds “supermajority” in the 465-member lower house. In 2019 Abe overtook Katsura Tarō to become the longest serving prime minister in Japan’s history.

This level of stability is a boon, says Kashima, particularly since Abe has committed to maintaining the policies of Abenomics, the mix of fiscal and monetary stimulus that bears his name. “Quite often an election in Japan is followed by wholesale changes to the roster of ministers and their portfolios but this wasn’t a feature of the most recent election,” she says.

4. Wage growth: Picking up the batonAs evidence of the growing strength and confidence of Japan’s business sector Kashima highlights the story told by wage growth data. After decades of stagnation, she says, large cap and international companies are now steadily increasing salaries. Average per-hour wages have maintained an upward trajectory but, crucially, given the decline in the working-age demographic, so has total employee compensation. This is significant for the health of the wider economy, says Kashima, given the interplay between rising income, domestic consumption and business confidence.

TOTAL EMPLOYEE COMPENSATION

Japa

nese

bill

ion

yen

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017240,000

245,000

250,000

255,000

260,000

265,000

270,000

275,000

280,000

285,000

Source: Cabinet Office, Government of Japan, December 2018.

5. Bank lending: the lifeblood of businessIf companies are going to invest in future growth then a benign lending environment is crucial. Here, the Japanese banking sector, with its loan-to-deposit ratio of less than 60% will play an important role. Consider how Japanese banks compare with their international peers. In the US, the loan to deposit ratio might be slightly better at around 70%, but in Europe 16 of 28 countries surveyed by the European Central Bank have average loan-to-deposit ratios above 100%.3

For Kashima this illustrates how Japanese banks have significantly more capacity to free up lending than many of their global counterparts. “It means that if Japanese businesses want to borrow money to maximise their potential, capital is available,” she says. “We believe this will be positive for earnings and growth from here on in.

LOAN/DEPOSIT RATIO: JAPANESE BANKS

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Loan/deposit ratio

Net deposits (left axis) Loan/Deposit ratio (right axis)Source: Bank of Japan, data ending at the end of August 2019. For illustrative purposes only.

6. Corporate cash build-upsIf banks have cash to spend; so too do Japanese corporates. This is partly due to Japan’s history of deflation: in a deflationary environment it made sense not to invest or spend. Assuming deflation ends and sentiment continues to improve, corporates could be more willing to run down that cash pile – with a positive knock-on effect both for the wider economy and for investors more generally.

ALL CHANGE: JAPANESE PRIME MINISTERS, 2005 – PRESENT

JUNICHIROKOIZUMI2001-2006

TAROASO

2008-2009

YUKIOHATOYAMA

2009-2010

NAOTOKAN

2010-2011

YOSHIHIKONODA

2011-2012

2005 2008 2011 2014 2019

YASUOFUKUDA2007-2008

SHINZOABE

2006-2007

SHINZOABE

2012- present

Source: Bloomberg, December 2017.

3 Forbes: ‘Loan-To-Deposit Ratios For Largest U.S. Banks Show Signs Of Recovery In Q1’, 13 June 2017.

Making the case: Active allocation to Japanese equities

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CORPORATE CASH BUILD-UPCash and deposits held by non-financial corporations

‘97Q4

JPY

Trill

ion

‘99Q1

‘00Q2

‘01Q3

‘02Q4

‘04Q1

‘19Q1

‘05Q2

‘06Q3

‘07Q4

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‘11Q3

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‘17Q4

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‘15Q2

‘16Q3

150

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190

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290

Source: Bank of Japan, data ending at the end of June 2019. For illustrative purposes only.

7. An underappreciated storyDespite the positives, international investors remain significantly underweight Japan. Between April 2003 to April 2006 net purchases of Japanese stocks came in at US$250bn. Between October 2012 to December 2013 that figure had fallen to US$180bn.4 The decline, says Kashima, may be because investors became overly focused on the perceived negatives of the Japanese investment story. Now, as Japan’s economy transitions to growth, that lag-effect looks set to reverse, which in turn could provide a tailwind for Japanese stocks.

But it’s not just international investors that are underweight the stock market. Japanese households also have a very low allocation to the stock market – accounting for just under 11% of household financial assets, according to the Bank of Japan.5 Says Kashima: “Given the performance of Japanese stocks over the past 20 years, this low allocation is hardly surprising. But we think that as the economy continues to improve and as companies continue to perform well Japanese savers will become more interested in buying shares, providing an additional tailwind to equities.”

JAPAN WEIGHTING IN GLOBAL EQUITY STRATEGIESJapan equity weight in global strategies

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(%) Overweight

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Source: Nomura Securities Co., Ltd., data ending March 2018. For illustrative purposes only.

8. The good news is not in the price…We’ve seen how Japanese stocks are underappreciated by global investors, but in fundamental terms they also appear to be undervalued. At least this seems to be case if we consider the comparative lag between the performance of Japanese indices and improving corporate earnings. As the chart illustrates, while earnings have recovered, the stock market has only broken out modestly. On this measure at least Japanese stocks appear to offer decent potential for a future uplift in pricing, concludes Kashima.

JAPAN TOPIX VS. TRAILING WEIGHTED EPSJapan equity weight in global strategies

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Japan TOPIX (left axis) Trailing EPS (right axis)

Source: Bloomberg, 30 September 2019, using 12 months trailing EPS. For illustrative purposes only.

9. A happy hunting groundGiven the opacity of the Japanese corporate sphere it’s perhaps no surprise that on-the-ground investment teams with in-depth sector, linguistic and cultural expertise tend to do better.

Often even larger companies are “off the grid” in terms of the wider investment community, says Kashima: they may not provide consensus estimates and the company may offer no forward guidance of its own.

Kashima’s team bridges the gap through local knowledge, face-to-face meetings with management and with its own forensic accounting. “We’re interested in opportunities that aren’t on the radar of the average investor,” she says. “Of course, it means you have to be extra careful to avoid hidden obstacles but you also get to discover those hidden gems before anyone else.”

4 Source: Nomura Securities Co., Ltd., data ending November 2017. For illustrative purposes only.5 Bank of Japan, as at September 2017.

Making the case: Active allocation to Japanese equities

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10. A new market phaseThose not convinced that Abenomics is working could do worse than consider the performance of the Nikkei 225 in the years since the Prime Minister launched his overhaul.

After flat-lining for most of the 1990s and 2000s, equity prices have seen a sharp improvement in recent years.

This is evidence of both a change in the mood among investors but also the strength of Japan’s domestic economy, says Kashima. “We believe those equity rises should be sustainable given the resilience of the economy,” she says, “and that Japanese investors will be well positioned for the upside when the global economy eventually bottoms out.”

A CLEAR CHANGE IN MARKET TREND

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Nik

kei 2

25 In

dex

Abenomics

Source: Bloomberg, data through end of 30 September 2019.

The value of investments can fall. Investors may not get back the amount invested.

Important informationFor Professional Clients and, in Switzerland, for Qualified Investors only. This is a financial promotion and is not investment advice. Any views and opinions are those of the investment manager, unless otherwise noted. This is not investment research or a research recommendation for regulatory purposes. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and its subsidiaries. Issued in the UK by BNY Mellon Investment Management EMEA Limited, BNY Mellon Centre, 160 Queen Victoria Street, London EC4V 4LA. Registered in England No. 1118580. Authorised and regulated by the Financial Conduct Authority. Issued in Switzerland by BNY Mellon Investments Switzerland GmbH, Talacker 29, CH-8001 Zürich, Switzerland. Authorised and regulated by the FINMA. Issued in Europe (ex. Switzerland and UK) by BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML), a public limited company (société anonyme) incorporated and existing under Luxembourg law under registration number B28166 and having its registered address at 2-4 Rue Eugène Ruppert L-2453 Luxembourg. BNY MFML is regulated by the Commission de Surveillance du Secteur Financier (CSSF). MAR000181. T8408 EXP: 31 March 2020 11/19.