The lessons everyone can learn from Japan

With the Nikkei 225 and Topix stock benchmarks touching two-year peaks, the yen at a 12-month high against the dollar and the economy putting together its best streak of quarterly GDP increases for a decade, investors could be forgiven for thinking that everything in the Japanese garden is rosy.

Yet the Nikkei 225 has underperformed for the second year in a row, in total return, sterling terms,

and Prime Minister Shinzō Abe still has to thoroughly convince the markets that his ‘Abenomics’ programme is working, even as he prepares to fight for a third consecutive general election victory in October.

Corporate performance has been good – even if Toshiba’s financial worries have continued to hog the headlines – and the Tokyo stock market is hardly expensive on earnings or book value metrics, even if its yield is unlikely to tempt income-seekers. But sceptics will point to the influence of the Bank of Japan’s (BoJ) colossal Quantitative Easing (QE) scheme, which leaves the central bank as a key influence on stock as well as bond prices.

Even if Governor Haruhiko Kuroda is running monetary policy at full tilt right now, investors will want to know what may happen if and when he ever decides to curtail monetary stimulus, or follow the US Federal Reserve’s path and contemplate withdrawing it.

Best performing Japan Large-Cap Equity OEICs over the past five years

Source: Morningstar, for Japan Large-Cap Equity category. Where more than one class of fund features only the best performer is listed.

Best performing Japanese investment trusts over the past five years

Source: Morningstar and the AIC, for Japan and Japanese Smaller Companies Categories. * Includes performance fee

Best performing Japanese Equity ETFs over the past five years

Source: Morningstar, for Japan Large-Cap Equity category. Where more than one class of fund features only the best performer is listed.

Political gamble

It may seem odd for a Prime Minister to gamble with a snap election, especially when recent ballot results around the globe have often featured nasty surprises for the incumbent, especially if they hailed from a so-called ‘establishment’ party.

France and the US saw complete outsiders win their Presidencies, the ruling Conservative Party lost its majority in the UK’s summer election and in the past week alone, nationalist parties have made great inroads in Germany and New Zealand, to leave their Chancellor and Prime Minister respectively scrabbling to form a coalition of some kind or other.

Abe should be on safer ground, especially as he himself is playing the nationalist card by pressing for changes to Japan’s avowedly pacifist constitution. Korea’s latest round of missile tests may mean Abe’s call to change Article 9 resonates more clearly with voters than before.

The PM is also picking his time quite carefully. He could have waited until December 2018 but has pounced now - as his own approval ratings begin to shrug off a number of grubby scandals, the opposition DPJ party remains in disarray and before the new ‘Party of Hope’ can build up a real head of steam under the charismatic Governor of Tokyo, Yuriko Koike.

Assuming Abe wins – and there are no certainties, although the cards are stacked in his favour – he can then start preparing for the 2020 Tokyo Olympics, set out his stall to become Japan’s longest-serving Prime Minister ever and also have another go at dragging Japan out of its debt mire.

Turning point

On the face of it, Japan’s economy is finally gathering some steam.

In the second quarter of 2017, Japan racked up its sixth straight period of growth, its longest run for a decade, and its best sequential rate of improvement for over two years.

Japanese GDP growth under Prime Minister Shinzô Abe

Source: Thomson Reuters Datastream

Whether this is down to the ‘Three Arrows’ of the ‘Abenomics’ reform programme, the Bank of Japan’s negative interest rate (NIRP) and Quantitative Easing (QE) policies, 2017’s fiscal stimulus programme, improved exports or a combination of all four is hard to divine. At least the results are tangible and they will be welcomed by both Prime Minister Abe and Bank of Japan Governor Haruhiko Kuroda alike.

However, sceptics will still argue Japan is still far from out of the woods in which it found itself so thoroughly lost when its equity and property bubble popped so spectacularly in the early 1990s.

• Every previous attempt to wean the economy off fiscal or monetary stimulus (or both) or hike interest rates has quickly come to grief and led to some serious backtracking by the authorities.
• Inflation is still woefully below the Bank of Japan’s 2% target, a threshold which has only briefly been crossed during the ‘Abenomics’ years.

Inflation has been consistently below target during the Abe-Kuroda years

Source: Thomson Reuters Datastream

• Hampered by weak growth and modest wage inflation, poor demographics and burdened by over two decades of (relatively unsuccessful) fiscal and monetary stimulus programmes, Japan’s sovereign finances are in a shocking state. Government debts come to around 240% of GDP, according to the CIA World Factbook. This is the highest such figure in the world and it leaves Japan in the less-than-exalted company of such economic problem children as Greece, Jamaica, the Lebanon and Italy.

Japan is still labouring under crushing sovereign debts

Source: CIA World Factbook, 2016

Markets

At least a forward price/earnings (PE) multiple of around 14 times and a price-to-book (or net asset value) multiple of 1.3 times, based on analysis from Société Générale, both suggest there may be some select value to be had.

This could particularly be the case if Abenomics does help to fire up Japanese growth or even just serves to persuade Japanese companies to be more shareholder-aware and focus on improved profits, return on equity and cash returns to advisers and clients.

One complicating factor remains the yen. In principle the Bank of Japan is far from concerned about defending its value, given its desire to electronically create ¥80 trillion yen a year out of thin air to fund its QE scheme, and this is understandable, as a weak currency could in theory help exports and give the wider economy a boost.

However, the yen is failing to stick to the script. The currency has marched from ¥117 to the dollar to ¥108, despite the ultra-loose monetary policy, and that has hampered the Nikkei as the inverse relationship between the stock market benchmark and yen stayed intact.

The Nikkei 225 and the yen continue to have an inverse relationship

Source: Thomson Reuters Datastream

Investors who are seeking exposure to Japan may therefore need to think about the currency or – if they prefer – buy an active or passive fund which comes with a currency hedge, albeit potentially in exchange for a higher-than-average annual fee, relative to an unhedged collective.

Central bank bonanza

The Bank of Japan’s role offers a further complication. As part of its QE plan, the central bank is not just buying bonds. It is buying exchange-traded funds (ETFs) too. Sceptics will therefore want to know why anyone should buy a market ...

• where the central bank was the single largest buyer of stocks in 2016
• where it owns three-quarters of the total assets in Japanese ETFs (according to research from Société Générale)
• and where the central bank is a top-ten shareholder across 90% of the stock market (according to Bloomberg)

What happens when the Bank of Japan stops QE and stops buying? Or tries to unwind it and starts selling?

At least it is unlikely that such a scenario is likely to develop any time soon. At the September policy meeting, the BoJ’s policy board voted 8-1 to leave QE and interest rates unchanged (at -0.1%) – and the one dissenter called for more QE, not less.

But after more than two decades of interest rates below 1.00%, multiple fiscal stimulus programmes and over a dozen rounds of QE since the early 1990s, Japan is the model that no western central banker wishes to emulate – and as such the Abe and Kuroda regime remains a key test case, as the European Central Bank and Bank of England continue to run ultra-loose monetary policy and the US Federal Reserve continues to tighten at a glacial pace.

Russ Mould, AJ Bell Investment Director