Investment Analysis and Research Insights
Maureen Kelliher, CFA, Senior Vice President and Investment Officer
Ryan Hanna, Vice President and Portfolio Manager
Tanya Stavreva, CFA, Portfolio Manager and Analyst
As investors look for opportunities within the global economy, Japan—which comprises approximately 8% of the global equity markets (as measured by the MSCI All Country World Index)—is an essential consideration. While the country has been in the clutches of economic paralysis for much of the past 25 years, there are a number of important factors that support an optimistic outlook.
Over the last five years, the Shinzo Abe administration and the Bank of Japan (BOJ) have led regulatory reforms and a robust stimulus program similar to that of other central banks in an attempt to dislodge the country’s entrenched deflation. These efforts appear to be paying off— helping to limit deflation and foster growth—and providing evidence that Japan may be able to mount a sustained recovery. We believe loose monetary policy will continue and that the central bank will be in no hurry to tighten supply, given the still-moderate levels of inflation.
There is a great deal of evidence to support a bright outlook:
- Japan’s industrialized, free market economy is the third largest in the world. At $4.4 trillion, it represents 6% of the global economy.
- Japan is a levered play on global growth. The economy is experiencing synchronized acceleration in 2017 and business sentiment is upbeat for the first time in almost a decade. The combination of foreign demand for Japanese goods and domestic consumption contributed to ongoing economic improvements across Japan. The third-quarter industrial output index grew by 0.4% to 102.5, a seasonally adjusted level not seen since 2008. Manufacturing sentiment and intended capex outlay are the strongest in 10 years.
- Year-over-year real gross domestic product growth in Japan reached a multi-year high of 2.5%* in the third quarter of 2017.
- Japan has maintained seven straight quarters of growth, its longest run of economic expansion since 2006. In addition, its inflation gauge has been steadily increasing and reached 0.7% in September 2017, the highest level in 29 months.
- Japan’s export position is strong. Known for its efficiency and competitiveness in its export-oriented sectors, Japan has the world’s largest electronics industry and the third largest automobile industry.
- Japanese equity valuations are compelling. Broadly speaking, valuations across Japan remain relatively inexpensive compared to other developed economies, at 16 times earnings as of December 15, 2017. The MSCI Japan Index forward price-to-earnings ratio is 15 times, versus its 10-year average of 18 times. In comparison, the forward PE of the MSCI All Country World Index is 18 times and the United States is 20 times.
- Japan’s weighting within global ex-U.S. portfolios remains low. Since the Japanese economy has experienced a number of false starts, international investors remain underweight Japan. Japanese stocks are therefore under-owned, providing plenty of dry powder to fuel a rally.
- Japanese tourism, an important economic indicator, is improving significantly with annualized tourist spending in the third quarter of 2017 equivalent to 0.8% of nominal GDP. In 2011, the Japanese government set a target of 40 million tourist visits to the country by 2020, up from less than six million at the time. With three years left to go in their time horizon, foreign visitors to Japan reached 29.5 million.
- Political leadership and the Bank of Japan will support further growth. The recent election results were positive for the Liberal Democratic Party and thus for Abe and Kuroda. With four more years to govern, the current administration will continue with easy monetary policy; some fiscal stimulus; further progress on corporate governance; and more women in the labor force. Additionally, the BOJ will continue purchasing domestic equities.
Risk Factors and Statistics to Watch
There are impediments to growth in Japan: an aging population; extremely low household formation; corporate cross-holdings; and other societal trends. These issues are longstanding, and mostly discounted in the price of Japanese stocks today. We outline some of these risk factors below.
Politics and Demographics
- The population is in decline. On average, Japanese women have 1.4 children, far fewer than what is needed to replace the loss among its aging population.
- At the current birth and death rates, the total population is projected to decline 25% by 2050.
- The combination of these factors has increased demand for yield and savings instruments, such as Japanese Government Bonds (JGBs) to meet retirees’ fixed income preferences.
- Japan’s highly insular immigration stance further exacerbates current and future labor market dynamics.
- Japan’s proximity to North Korea makes its geopolitical risk high, especially given the uncertainty surrounding North Korea’s leadership and its nuclear proliferation.
- At stressed ratios of 300% Gross Debt/GDP and 200% Net Debt/GDP, if debt confidence falters, there could be significant adverse repercussions for economic stability. This makes inflation and economic growth not only desirable but required to ease the debt burden.
- However, across individuals and institutions, close to 90% of government debt is held domestically (the BOJ now holds 45% of JGBs), favorably mitigating potential external vulnerabilities.
- As long as bondholders stay invested and are satisfied with close-to-negative real rates of return, current debt levels are theoretically sustainable and can even expand.
- The economy is slowly exiting deflation, but inflation is still struggling to trend beyond 0.5%, well below the BOJ target of 2%.
- Wage growth of approximately 2% is some of the strongest since the mid-1990’s.
- Unemployment is down to a 22-year low (2.8%) and any further wage growth will help with meeting inflation goals.
- The Tokyo Olympics in 2020 will bring massive investments leading up to the start of the Games, similar to what was experienced in Rio de Janeiro in preparation for the 2016 Summer Games.
Stock Market and Currency
- The MSCI Japan Index is up 22.6% in dollar terms year to date through December 15, 2017 and is outperforming the S&P by approximately .7% (70 basis points). There may be a pause in the rally, but the long-term case for further upside remains.
- The level of the yen is also an important ongoing consideration. A weaker yen typically helps the large exporters that dominate Japan’s stock market indices. A weaker currency is also often associated with more optimism and aggressiveness from global investors. Should the yen appreciate, it could negatively impact the stock market.
The Cambridge Trust Conclusion
We believe the Japanese stock market is an attractive long-term investment. A return to growth, continued stimulative monetary policy, and reasonable valuations support a bullish case.
However, investors must be cautious because Japan has one of the most complicated, leveraged financial systems in the world. In theory, the complex, intertwined Japanese financial system could sustain itself for a long time to come, given excess savings and a healthy government borrowing program. If these conditions hold, investors can see positive return and diversification benefits.
All factors considered, we have been selectively adding small exposure to Japan in our internal strategies. Japan remains a major part of the global economy and is appropriate for global diversification in client portfolios on the basis of its improving fundamentals after decades of malaise.
* Real, non-seasonally adjusted, chained GDP ... Q3 2017 year-over-year
Note: This Thought Series article was written by Cambridge Trust Wealth Managers using various data sources, including Bloomberg, FactSet and the World Economic Forum.