Asset And Portfolio Managament

Japan: The arrows hit the mark

It has been nearly five years since the ‘marksman’ took aim; Abe’s arrows now look like they are hitting the mark on the economy.

Prime Minister Shinzo Abe embarked on a series of economic reform policies aimed at jostling Japan out of its ‘lost decades’ of sluggish growth, with the famed ‘three arrows’ of fiscal stimulus, monetary easing, and structural reforms. As the output gap has closed in recent years and macro-indicators are now pointing to an improving backdrop, are Japanese equities ripe for a catch-up trade? At the same time, the potential for policy missteps remains an area of concern as the economy walks the tight rope with the longer-term deflationary pressures still at play. In this note we delve into the key aspects driving the Japanese market and how investors can position themselves.

The recent Tankan Business survey, released on 31 March, revealed an improving backdrop for Japan. The message from the survey for the first quarter was that companies were more upbeat on business conditions, helped by a weaker currency, and poised to boost investment. Large companies in all industries forecasted on average a 0.6% increase in investment for fiscal year 2017 versus a consensus cut of 0.3%. Another encouraging sign for reflation was that companies were gaining a little more pricing power, with expectations of output prices rising by 0.4% from current levels. Industrial production came in with solid 2% month-on-month growth, beating expectations of 1.2% and thus providing another signal of the gathering momentum. The tightening labour market remains a dichotomy; on the one hand it poses challenges for certain companies, whilst on the other hand it offers support to the economy’s reflation via wage increases.

Chart 1 shows the employment index that measures the degree to which firms think they have an excess or shortage of workers, thus providing insight into how tight the labour market is. This is an important measure for the Bank of Japan (BoJ), as it is counting on a tight labour market to stoke inflation. As shown, the market has become increasingly tight as longer-term demographics weigh in; however, there are cyclical trends at play, and the overall impact on firms is not adverse.

Chart 1: Japan employment conditions
Chart 1: Japan employment conditions
Source: Bloomberg Finance LP, Factset, SSGA, as of 31 March 2017
Labour shortage: A challenge and an opportunity

Japan’s demographics have long been thought of as a deflationary factor. In the long term, the prospect of demographic pressures resulting in both lower steady state output and prices will likely hinge on whether Abenomics succeeds in maximising potential labour inputs and raising productivity. However, at least in the medium term, the improvement in demand is likely to outstrip the decline in labour supply, thus stoking inflationary pressures.

Structural and cyclical forces could combine to exert upward pressure on macro-wages and broader inflation. On the cyclical front, the economy is currently in the midst of a solid pick-up, as shown in March’s Tankan survey, after stalling post the 2014 consumption tax hike. On the structural front, Japan’s baby boomers are now past the retirement age while participation rates among women and the elderly have already improved quite notably. Moreover, the government’s pursuit of ‘work-style reform’ intends to prevent long working hours (including unpaid overtime) and to narrow the compensation gap between full-time and part-time workers, which could interact with the labour shortage to deepen the challenges faced by businesses.

Nevertheless, as large companies in the investable universe confront the tightening labour market, wage increases may not be the first response. Large corporates tend to be more capital-intensive, so they are less constrained by a labour shortage at this stage. That does not mean, however, that wage inflation pressures will not build at all for large companies. Sectors facing labour shortages more acutely are the less capital intensive, such as the land transportation industry and convenience stores.

On the flip side, labour shortages are forcing firms to automate, which gives Japan a significant and important edge in robotics. Production of industrial robots has surged: ‘intelligent’ robots have seen a marked increase over the past three years, more than doubling in number.

Innovation and a shift towards niche industries could also allow Japan to remain competitive in the face of a stronger yen, a point underlined by the recent trade numbers for February. The trade surplus is widening again: the 12-month moving total was the highest since March 2011 (see Chart 2). Machinery exports have rebounded swiftly over the past year. A strong yen need not be negative for equities. The overseas production ratio remains high, which benefits input prices.

Chart 2: Japan trade balance (12-month rolling total)
Chart 2: Japan trade balance (12-month rolling total)
Source: Bloomberg Finance LP, SSGA, as of 31 March 2017
The yen and equities: A hand-and-glove relationship

Given the importance of the export economy, Japanese stock markets have had a strong correlation with the foreign exchange rate. Chart 3 depicts this relationship where a weakening yen is typically positive for the stock market, as it makes Japanese products more competitive internationally, whilst the converse also applies. The BoJ embarked on a substantial easing policy as part of Abenomics, which was well received in the market as it led to a weakening of the yen (highlighted in the chart). However, the effectiveness of monetary policy globally is starting to wane, and Japan is prone to safe-haven flows when risk events occur. This can easily lead to a strengthening of the yen, which in turn can weaken the outlook for the market. The recent Tankan survey for the first quarter shows that large manufacturers expect the exchange rate to be 108.43 for fiscal year 2017; with the currency currently around 111, the outlook may imply upside to sentiment if the yen remains weak.

Chart 3: Correlation of stock market and the exchange rate
Chart 3: Correlation of stock market and the exchange rate
Source: Bloomberg Finance LP, SSGA, as of 31 March 2017

That said, the equity market is not entirely a currency play. Japanese equities have recently underperformed global share prices (since the latter half of December) due to concern over the Trump administration’s proposed border adjustment tax. As the US is Japan’s largest export market, this would impact many firms. However, with a high equity risk premium factored in, Japanese equities could rebound once the market begins pricing in – for better or worse – a potential lack of progress on President Trump’s policies and focus shifts instead to the improvement in the real economy. Earnings revisions have risen sharply in 2017 as the weaker yen, domestic reflation, and global growth are providing a tailwind for corporate earnings. Valuation continues to be attractive both historically and relative to other regions. The Chart 4 shows the comparison of price to book for Japanese, US and European stocks since 2000. Japanese stocks have a higher return on equity (ROE) compared to European stocks, but the valuation is still lower. On a relative valuation basis, this factor could provide an impetus for investors – especially given the recovery in capital expenditure and consumer spending in Japan.

Chart 4: Regional valuation comparison (price to book)
Chart 4: Regional valuation comparison (price to book)
Source: Bloomberg Finance LP, SSGA, as of 31 March 2017.
To hedge or not to hedge

Since the onset of the BoJ monetary stimulus, hedged flows into Japanese equities have outpaced unhedged as currency has had a significant impact on returns (Chart 5). With any foreign currency investment, investors are not only exposed to movements in the underlying assets but also to any changes in the value of the portfolio currencies relative to the home currency. Over the business cycle, the currency impact on a portfolio may be minimal as valuations mean revert. However, as we saw in 2015 and 2016, there can be extended periods of mispricing in the market when currency can detract from a portfolio’s short-term return. Given the correlation of the stock market to the exchange rate, investors may consider accessing the market via a hedged exposure if they want to mitigate these effects.

Chart 5: Hedged flows outpace unhedged for Japanese equities

European domiciled ETFs in euro

Chart 5: Hedged flows outpace unhedged for Japanese equities
Source: Morningstar, SSGA, as of 31 March 2017

Hedging currency exposures has historically been a subject for academics to pontificate on and for large institutional investors to deploy. Fortunately, with the proliferation of ETFs, currency-hedged ETFs have democratised this sophisticated strategy, enabling investors to access it in a cost-efficient manner.

Conclusion

The economic backdrop in Japan is improving, buoyed by stronger domestic demand and a better global growth outlook, which helps external demand. There are currently cyclical improvements in the economy; however, the longer-term structural challenges persist. The encouraging signs are that Abe’s policies seem to be making headway and the feedthrough is boosting corporate confidence, which could be key to a sustained economic recovery. As the third largest economy in the world, Japan is a significant component in investors’ portfolios, and equities provide an opportunity to gain exposure to the evolving dynamics. Given the historical relationship with exchange rates, a hedged exposure may be preferred, and ETFs provide a simple, transparent and efficient way to access the market.

Commerzbank Disclaimer
The views expressed in this article are those of the author and may differ from the published views of Commerzbank Corporate Clients Research Department, the communication has been prepared separately of such department. No representations, guarantees or warranties are made by Commerzbank with regard to the accuracy, completeness or suitability of the data.