Category Investments

Japan remains compelling investment despite recession

28 November 2014 Old Mutual

By reducing investment exposure to Japan based purely on two quarters of negative GDP growth, investors stand to lose far more in missed long-term opportunities than they may gain by reducing their short-term risk exposure. This is according to Urvesh Desai, Portfolio Manager and Strategist for Old Mutual Investment Group’s MacroSolutions boutique, who says that any sound investment approach must recognise GDP as just one of a multitude of factors that will drive markets and prices in the long term.

Japan’s recent and unexpected economic decline into what is technically a recession, took most investors somewhat by surprise and prompted many to keep their focus on global destinations that are demonstrating more obvious positive growth outlooks, most notably the USA. 

“We place a greater emphasis on macro-economic data for our asset allocation process than does the typical stock picking investment approach,” Desai explains. 

“With a macro overview in mind, we consider key investment and market themes, built around significant and lasting changes in the economic, corporate and social environment. We believe these will drive prices over extended periods, and they therefore guide our investment decisions.” 

Desai believes that, when viewed against the MacroSolutions’ theme and price-based investment philosophy, the current environment and relative valuation levels for Japanese equity make for “a compelling picture that has not been seen for some time, and has spurred us to increase our current overweight position”. 

Unpacking this positive take on the Japanese markets, he highlights a number of other economic factors that lend further lustre to many Japanese stocks. 

One of these key thematic components is inflation and monetary policy (as the two are linked). Desai emphasises that while the surge in Japanese inflation, compared to the still below target figures in the US may seem to support investment exit from the former, one should not lose sight of the fact that Japanese inflation is not a symptom of economic problems, but rather a consequence of deliberate monetary policy in that country. Monetary policy is a key theme that needs to be considered by investors when comparing the investment prospects of both nations. Both Japan and the US have near zero interest rate policies, and have moved on to quantitative easing (QE). 

“While America has completed its tapering of QE and is now not easing further, Japan is accelerating its program which, relative to the size of its economy, is the largest QE stimulus in the world.” 

Against this policy backdrop, Desai points to a careful analysis of company earnings and profits in both regions as the most important consideration for equity investors weighing up their options. Japan’s stimulus package has caused its currency to weaken which is good for exports. A key distinction between GPD and the equity market for Japan is that exports make up less than a fifth of Japan’s GDP. However, export-related sectors make up twice as much of the equity market. So the equity market will likely benefit more from the weak currency than the economy as a whole. 

“While earnings in the US may have been growing strongly recently, return on equity has actually been trending lower since the middle of 2012,” he says, “whereas, in contrast, Japan has been experiencing positive return on equity trends, bolstered by steady improvements in margins thanks to an increasingly competitive currency.” 

Desai goes on to explain that this particular investment theme is strengthened further by the fact that Japan has recently been making a concerted effort to improve the return on equity delivered by its companies, mainly to address the historical tendency within many Japanese companies to overlook shareholder value. 

He says the introduction of the new JPX-Nikkei 400 Index - or shame index as it has been dubbed - is a deliberate attempt by the Japanese to drive a fundamental change in management behaviour to increase shareholder value over time. He contends that the positive investment impact this will have will be further boosted by the inclusion of exchange-traded funds (ETFs) that track the index in the Japanese QE program, as well as the stated intention of Japan’s massive GIPF pension fund to allocate part of its equity exposure specifically to funds that track this index. In addition, the GIPF recently also announced that it is increasing its strategic allocation to Japanese equities. In an environment where inflation is rising and interest rates are low, real interest rates will effectively be negative. This represents a form of tax on investors in bonds and so switching assets from Japanese bonds to Japanese equities makes sense for the GIPF and all other Japanese pension funds. 

“Given these long-term themes of improving profitability and rising demand for equities coupled with a good relative value, Japan remains a very positive investment story,” Desai concludes. “An investment approach, which does not crumble in the face of some short-term factors, is the only real sustainable wealth management option.”


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