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Team Japan pulled off its best-ever Olympic performance in the Tokyo games, winning 27 gold medals. Likewise, in the long run we think the nation’s markets are poised to perform, as they appear well-positioned for a period of higher inflation in the wake of record stimulus spending globally.
No doubt, it takes courage to call a revival of Japan’s stock market following decades of deflation and sluggish domestic growth that has culminated in ‘Japanification’ becoming a byword for economic atrophy. Japan has often been seen as a market for tactical rather than strategic allocation, overshadowed by a faster growing Chinese economy and stronger US equities.
However, the country is starting to show signs of rejuvenation: Japan stands to emerge as a net winner from shifting global economic conditions in the wake of the Covid-19 pandemic, with growth further invigorated by deep domestic reforms targeting structural challenges. At the advent of an inflationary era, it is better positioned than most nations, while the reappraisal of traditional 60/40 portfolios is prompting global investors to take a new look at Japan’s diversification appeal. At the same time, domestic policies targeting capital efficiency, shareholder value and sustainability could bolster investor confidence.
New economic order
The rise of inflation represents a true paradigm shift in a world recovering from Covid-19. As the global economy slowly recovers, an era of low inflation looks set to end following unprecedented fiscal and monetary stimulus worldwide. Japan Inc. stands to benefit from future price hikes, with a benchmark equity index tilted towards sectors that tend to outperform in periods of rising inflation, such as automakers, machinery companies and producers of consumer durables.
The automobile sector accounts for about 9 per cent of the TOPIX, compared with 2 per cent for the S&P 500 and around 3 per cent for the MSCI World. Auto-related stocks have historically had the highest positive correlation with inflation among all sectors, followed by machinery, another prominent segment of the TOPIX. In previous inflationary periods, Japanese manufacturers have been able to retain impressive pricing power and pass on the impact of cost hikes to their customers around the world.
The US market, on the other hand, has a high concentration of consumer discretionary stocks, which historically have had the worst negative correlation with inflation among sectors. If the past is a guide, Japan tends to offer strong diversification benefits to US equity investors in an inflationary era.
In response to inflationary pressures, central banks are signalling a tapering of quantitative easing, but this alone may do little to alter the course of long-term price hikes. Before long we expect interest rates to rise across the maturity curve and this could turn a long-standing drawback of Japan into a new edge: it has the lowest corporate leverage among major economies. In fact, Japanese stocks tended to outperform global peers during periods when real US interest rates rose over the last 12 years.
Japan Inc. has been (in)famous for its excess cash pile that in the past has limited investor returns. The average TOPIX firm holds cash equivalent to more than a quarter of its market capitalisation, compared to around 8 per cent for the S&P 500 and 11 per cent for the STOXX Europe 600. However, Japan’s cashed-up corporates are well positioned to enter an era of rate hikes, as they have the lowest debt-servicing burden among major markets. Abundant cash would also allow Japanese firms to pay more attractive dividends or repurchase more shares than those in other developed countries. While European and American firms widely slashed their 2020 dividends in the wake of Covid, the TOPIX only saw a marginal decline in dividend payouts.
Over the last two decades, global investors have grown used to hedging their equity portfolios with bonds, in a strategy known as 60/40 allocation. But this popular approach may be losing its appeal, as stock-bond correlations started to turn positive this year, forcing investors to search for new sources of diversification. In fact, stocks and bonds tended to move in tandem during some inflationary periods before the 21st century. The answer to those seeking alternative diversifiers in the coming era of price hikes may well be Japan.
The structural reform imperative
Internally, Japan’s structural reforms are creating potential drivers of secular growth over the medium term. Regulators and institutional investors have both stepped up efforts to unlock trapped value through the improvement of capital allocation and governance. A campaign started by the former Prime Minister Shinzo Abe to boost capital efficiency and increase shareholder value has contributed to gradual progress in recent years, but more needs to be done.
Cross shareholdings, which can prevent investors from holding company managers to account, have visibly declined in the Japanese market. Stock ownership by business corporations shrank by 1.9 percentage points, the most in 20 years, to 20.4 per cent in the fiscal year through March, according to the Tokyo Stock Exchange. Although the change has been gradual, having more shares in the hands of pure investors should help to boost governance.
In a sign of improved capital efficiency, private capex has steadily recovered over the last decade - official data show quarterly private nonresidential investment climbed from 75 trillion yen at the end of 2012 (when Abenomics began) to a high of 93 trillion yen in 2019, before pulling back in the pandemic.
The way forward
Regulators revised the country’s Corporate Governance Code in 2018, and again in June this year, seeking to enhance disclosure, board independence, gender diversity and environmental and social practices. As a result, corporate activity, including divestments, the unwinding of parent-child listings, and mergers and acquisitions, have markedly increased in recent years, while investor activism is also on the rise. The value of domestic mergers and acquisitions more than doubled to 6.2 trillion yen (around $57 billion) in 2019, a 12-year high, before pulling back last year during Covid. As part of Japan’s listing reform, corporate governance will serve as a criterion for selecting stocks for inclusion in the prime segment of the TOPIX, starting in 2022.
Meanwhile, global investors like Fidelity have been actively engaging Japanese firms on their environmental, social and governance practices. ESG is quickly rising up boardroom agendas in the country. Japan’s wider embrace of sustainable investing is further strengthening the case for long-term strategic allocation.
Overall, though encouraging, changes in the corporate sector remain relatively slow and incremental. It may take longer to convince global investors that conditions are ripe for being overweight Japan. In addition, inflation may be kept in check by new Covid variants that slow global demand.
Nevertheless, the catalysts for global investors to reconsider a bigger allocation to Japanese equities appear to be in place. While the Olympic baton has been passed to Paris for 2024, Japan’s markets look like they have a good long run ahead.