Geographic View: Japan: Land of the missing bull?

Geographic View: Japan: Land of the missing bull?

By Matt Le Cornu, Ashburton

Matt Le Cornu is a member of the Bespoke Portfolio team at Ashburton. After a recent visit to Japan he gives his thoughts on the future of this market.

Japan became the “darling” of global equity investors in the late eighties. Share prices rose steeply from 1986 till their eventual peak in late 1989. This momentum, however, could not be sustained and on 29 December, 1989 the bubble finally burst. The consequences of this were a protracted recession and Japan’s “lost decade”, which finally bottomed in April 2003. Since this juncture, investors large and small have been waiting for the re-emergence of Japan, when its equity market once again begins to deliver sustained returns. These were the issues facing me on my first visit to Tokyo earlier this year.

Upon arrival, it became apparent that Japan embraces modern times whilst retaining a strong sense of history. Imposing skyscrapers overlook centuries old Shinto Temples and traditionally dressed Geishas are interspersed amongst fashionable and technology-aware teenagers. Although projecting a visage of a modern society, it was fascinating to see this culture’s balance between new and old.

The conference I attended was a gathering of institutional equity investors with varying mandates, ranging from global and regional funds to Japanese equity only managers who, although gluttons for punishment, continue to fight on. Most attendees were definitely of bearish persuasion as the first day began, especially after the poor showing of the markets in 2007. After a number of presentations by both domestically-focused and export-orientated Japanese companies, it became apparent that both parties have a hard road ahead of them.

Consumer spending continues to be uninspiring with growth in real wages remaining flat to negative. This was emphasised by a visit to a leading department store. The pavements were highly congested; so much so that was difficult to move. However, inside the store, there appeared to be six members of staff for every one customer.

Demographics are a major issue for Japan. It has one of the lowest birth rates in the world and an increasing number of post-war baby boomers starting to reach retirement age. Combine this with an average life expectancy of 81 years and there is a significant risk if not likelihood of the cost of social benefits outstripping that of new entrants to the workforce. Hardly surprising then that savings rates are so high in this country.

Numerous factors are also combining to hold back the bottom line of companies targeting export markets. Risk aversion and the unwinding of the lucrative yen carry trade (whereby investors borrow low yielding yen and invest in high yielding currencies such as the New Zealand dollar), has driven the yen to three-year highs against a weakening US dollar. Furthermore, demand from the US is faltering as that economy heads into recession.

Corporate governance (or the lack thereof) remains a significant deterrent to foreign participation in the equity market, turning many investors away. A number of companies have recently adopted poison-pill measures to deter would be predators, or increased their cross-holdings, whilst maintaining one of the lowest payout ratios in the world.

All this said, there was some good news for those prepared to listen. Japanese equities are very cheap by historical standards. Valuations of around fifteen times earnings match those available some thirty years ago. Japanese export profits will be affected by the global slowdown, but more than ever, their increasing exposure to emerging economies should lessen the downside and prove profitable in the future. Corporate Japan appears to recognise the challenges they need to face up to going into 2008, with an increased focus on expanding product ranges and diversifying geographically.

Domestic factors may also suggest a rosier future. If ongoing union negotiations are effective in achieving increased wages, they could assist domestic demand. With the stronger yen hampering export growth, the upcoming G8 summit may mark a point where the authorities commit to intervention in the foreign exchange markets. Furthermore, the need for government to commit to a meaningful reform agenda is now widely recognised. However, these are possible rather than probable outcomes.

A major spark is needed to re-ignite the market and the economy. For the time being, however, and other than a strongly contrarian view, it would be difficult to promote a bullish view on Japan.

Japan's position in Asia

By Jonathan Schiessl, Investment Manager and Asia-Pacific Specialist, Ashburton

So what are our thoughts from a broader Asia Pacific perspective?

In a nutshell, we are still ambivalent about Japan’s short term prospects. Within the Asia Pacific Equity Fund we are currently holding a 45% weight to Japan. Whilst sounding high, this is actually significantly underweight compared to our benchmark.

Since global equity markets bottomed in 2003, Japan has significantly underperformed its Asian neighbours. In this time, however, there are two brief periods (highlighted) of extreme Japanese outperformance. Both these periods saw Japanese stocks gaining strongly due primarily to political catalysts.

However, hopes of meaningful reform seem to have petered out with the departure of the enigmatic PM Koizumi, and since that period, Japan has become a value trap.

So what are we to make of the recent outperformance of Japan that can clearly be seen on the chart. Our take on this is twofold: firstly a strengthening yen accounts for most of the outperformance, and secondly Japan has merely fallen less than its neighbours, because it had fallen so far already this year.

And the future? There are positives out there, but we will not be persuaded to significantly increase our weightings until we see a concrete catalyst emerging. And as that is likely to be political once again, we might have to wait a while longer.

Key Points

· Japanese equities are very cheap by historical standards. Valuations of around fifteen times earnings match those available some thirty years ago.

· There are positives out there, but we will not be persuaded to significantly increase our weightings until we see a concrete catalyst emerging. And as that is likely to be political once again, we might have to wait a while longer.

· Demographics are a major issue for Japan. Combine this with an average life expectancy of 81 years and there is a significant risk if not likelihood of the cost of social benefits outstripping that of new entrants to the workforce.

· Corporate Japan appears to recognise the challenges they need to face up to going into 2008, with an increased focus on expanding product ranges and diversifying geographically.

· Corporate governance (or the lack thereof) remains a significant deterrent to foreign participation in the equity market, turning many investors away.