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As a new inflationary era descends on many parts of the world, Japan has been an exception. Once known for its 15-year deflationary spiral, Japan’s emergence today as a relative oasis of macro stability and growth caps a narrative of changes that has in fact been long underway.
The Japanese economy has been riding a recovery since around 2012 that has been as steady as it is low-profile. But lots of investors have missed it. Blame that on misplaced presumptions dating back to Japan’s “lost decade” of the 1990s and 2000s (which the Japanese more accurately call “the lost two decades”), a time when economic shrinkage and deflation defined its economy.
But that hasn’t been Japan for some time. In nominal terms, the economy has grown an aggregate 8.9 per cent in the decade to 2021, barring a temporary Covid pullback in 2020. Capital expenditure is up about 17 per cent over the same period. Total wages are up about 12 per cent. This is no accident: domestic policies targeting capital efficiency and sustainability have survived successive administrations over this time frame.
All of which means the economy is well-positioned for the post-Covid era, even if it entails a period of higher inflation globally. That is probably so, even with Tokyo’s latest consumer price index touching 1.9 per cent excluding fresh food. The yen has weakened recently, in part because of the Bank of Japan’s declared commitment to keep rates low, and we think policymakers still have room to tolerate more inflationary pressure. The government has ordered a range of measures to shield consumers from the impact of rising costs. And while the nation might not be completely immune from a spillover of stagflation, Japan’s macro contrast to its Western peers couldn’t make its diversification appeal any clearer.
Of course, the yen weakening to extraordinary lows has created some jitters. Rapid currency movements are always tough over the short term. Management sentiment in April dipped more sharply than anywhere else in the world, driven primarily by worries over costs, according to Fidelity International’s latest monthly Analyst Survey. One worry is that the plunge in the yen aggravates the impact of globally surging commodity prices, hitting suppliers that depend on imported materials and consumers. But a weaker currency can still be positive for the economy, in some regards, such as boosting export competitiveness and the value of repatriated overseas profits. Japanese companies can adjust given time - and the current level is within range of what they have experienced in the past.
An elusive target
The weaker yen and higher commodity prices might finally get the economy to the Bank of Japan’s elusive 2 per cent inflation target. A bit of inflation would be welcome in this context. A dose of upward price pressure would also be a plus for Japan’s benchmark equity index, which is heavy on sectors that generally account for a high proportion of exports such as automakers and consumer durable goods makers.
To the extent that inflation leads to upward pressure on wages, it can pose a macro risk if it spirals out of control or is mismanaged. But healthy levels of wage inflation can bring notable benefits, not least by boosting consumer spending power. Japan has long lagged other major economies in this metric, and policy makers have spent years trying to prod companies to pay employees more. The campaign appears to be bearing fruit, and we think it’s just at the beginning of a positive cycle. And changes in labour laws and tax incentives point to continued policy support for total wage growth.
Broader reforms in focus
It’s clear Japan isn’t the same economy it was a decade ago. Regulators have been busy refining Japan’s corporate governance code, aiming to improve disclosure, board independence, gender diversity, and environmental and social practices. Market reforms currently underway have focused attention to the requirements for independent board members and climate disclosures.
Fidelity analysts in our April survey said companies in Japan are accelerating business plans to achieve net zero carbon emissions more aggressively than most of the rest of the world. At the same time, women holding directorships are on the rise, which at 7.4 per cent of all boards last year is more than double the proportion in 2017. The fraction of top Japanese corporates with independent directors on a third or more of their boards has risen 11 times since 2014 to 73 per cent last year. As global investors including Fidelity initiate discussions on sustainable investing practices with Japanese firms, they are finding these companies now much more receptive to investor engagement than in the past.
Primed for growth
Japan’s corporates remain flush with cash, paired with the lowest debt-servicing burden among major markets, positioning them to weather even a future potential return to rising rates and weaker economic growth. But stable economic conditions don’t always make for headlines - one reason global investors, and even domestic ones, are often underweight exposure to Japan. Only 10 per cent of the financial assets held by the nation’s households are made up of domestic equities, compared with 38 per cent in the US and 18 per cent in Europe. That’s a lot of room for savvy investors to close the gap.