Mark Lister, 24 August 2017

Japan is the world’s third largest economy and home to many leading global industrial and technology companies.

For many investors, Japan is all too easy to ignore. We all know the story… the Japanese economy has been overburdened with debt and mired in a deflationary malaise for more than 25 years. Over this period of time there have been several false dawns and these relatively short-lived bouts of optimism have seen the Japanese sharemarket experience spectacular rallies, only to make new lows when it became apparent the economy would continue to grapple with high debt levels and deflation.

It is not our intention to minimise the challenges Japan faces. Rather, we argue that the negatives associated with Japan are well appreciated and thus largely priced into Japanese equity valuations. Meanwhile, the positive catalysts for the Japanese economy and sharemarket are far less understood. With Japanese equities attractively valued relative to other markets, and with the outlook for the Japanese economy and sharemarket improving, it is our view that Japan can outperform global markets over the next several years.

Japan graph

We should acknowledge that high debt levels and persistently low inflation are no longer a Japancentric problem. All developed world economies, and indeed many emerging market economies, are grappling with elevated total debt levels, slow growth and persistently low inflation. Yet only Japanese equities receive a valuation discount to account for potential deflationary risks. This inconsistency is becoming increasingly difficult to justify.

Any analysis of Japan’s fiscal condition must also consider the other side of the country’s balance sheet, its assets. By any measure, Japan is an extraordinarily wealthy country. Japanese household wealth currently stands at c250% of GDP, and the corporate sector has a net foreign asset position equal to 70% of GDP. The wealth of the Japanese private sector helps to explain the apparent paradox that Japan is both the world’s most indebted major developed economy (public sector debt) and the world’s largest creditor (private sector wealth).

Finally, not all debt is equally onerous. History teaches us that countries that get into trouble with debt typically run negative trade balances and have high levels of foreign currency borrowing. Neither of these circumstances applies to Japan. On the contrary, Japan has run a persistent trade surplus with the world for over 30 years and has funded government spending almost exclusively via domestic savings. These are not the preconditions of a crisis and, if anything, help to explain why Japan has been able to manage its debt burden far longer than most academics and investors would have expected.

So, perhaps Japan’s balance sheet is not as troubling as it first appears. That alone may not be sufficient to build a bullish case for Japanese equities. Fortunately, we can point to several reasons to be constructive on Japan. This view is supported by both a historical perspective and recent experience, which suggests that aggressive central bank policies primarily benefit asset prices.

To begin with, it would be difficult to argue that the unconventional monetary policies pursued by the world’s central banks have not been instrumental in the extraordinary bull market in risk assets we have witnessed over the past several years. With this in mind, it is noteworthy that the Bank of Japan is at the forefront of unconventional monetary policy and is likely to remain so. We have little doubt that the world’s most aggressive central bank will continue to surprise markets with its willingness to do whatever it takes to end deflation in Japan.

Secondly, while monetary policy has been a key driver of the Japanese sharemarket, there is some evidence that the Japanese economy was beginning to mend even prior to the aggressive policies implemented by the Bank of Japan. Many of Japan’s problems have been rooted in demographics; namely an ageing population and excess savings. Initially, this combination was highly deflationary. However, as the population has continued to age, the size of the working age population has been reduced significantly. There are now fewer and fewer workers available to perform the same number of jobs. This has put an end to wage deflation.

Japan graph 2

In another notable development, private sector credit growth recently turned positive for the first time since the late 90’s. In our view, it is no coincidence that this releveraging of the Japanese private sector coincided with the Japanese economy expanding in the past five consecutive quarters (the longest period of expansion in 11 years). Should Japanese wages begin to increase as the pool of excess savings continues to decrease, this would go a long way to ending the deflationary mindset that has plagued the Japanese consumer.

Finally, and somewhat counterintuitively, extremely low expectations for the Japanese economy and sharemarkets are one of the more compelling reasons to own Japanese equities. One of the great paradoxes of investing is that what is easy is rarely the correct course of action. Similarly, the best opportunities often come from companies or asset classes where sentiment is uniformly negative.

The outlook for Japan continues to improve against a backdrop of a highly accommodative central bank and very low market expectations. Should the Japanese economy continue to improve as we expect, there is a lot of room for a positive shift in expectations, and a corresponding rise in Japanese share prices. However, the end of deflation in Japan doesn’t necessarily mean a return to stable inflation. As a result, risks surrounding an investment in Japan centre on exposure to a currency that in all likelihood must weaken significantly for Japan’s economy to improve.

A little history shows where Japan is likely headed

It is a little known historical fact that Japan was the first country to exit the great depression. Japan was able to return to growth and inflation in 1932 through a combination of policies, including currency depreciation, accommodative monetary policy, and fiscal spending financed directly via the Bank of Japan. These policies were effective primarily because they resulted in a large devaluation of the Japanese yen relative to the country’s major trading partners.

In our view, such an outcome is once again inevitable, with very positive implications for Japanese equities. The Bank of Japan cannot allow the Japanese yen to continue to strengthen to the detriment of the economy. The policies it has thus far implemented, which include negative interest rates and anchoring the long end of the yield curve, are far more experimental than those implemented by other central banks.

We firmly believe that the end game for Japan will again entail the direct financing of government spending by the country’s central bank. This is a form of ‘helicopter money’. If such a radical marriage of fiscal and monetary policy may seem unlikely, it is worth pointing out that so did quantitative easing and negative interest rates.

In our view, Japan will once again be the first mover, and the first country to escape the deflationary forces plaguing the global economy. History suggests that the result of ever more radical central bank policies will be much higher prices for Japanese equities, and a material devaluation of the Japanese yen.

Please note: This article was first published in the August 2017 edition of News & Views under the title “Outlining the investment case for Japan”. Craigs Investment Partners clients can view the latest edition of News & Views, which includes the full version of this article, by logging in to Client Portal.