Bloomberrg/Takaaki Iwabuby William Mullally
Earlier this year, we further raised our allocations to Japanese stocks, with near-term catalysts including: increased strength in bottom-up corporate earnings; evidence of ongoing corporate reform driving better shareholder returns; firm economic expectations; receding political risks, with Prime Minister Abe having secured a strong victory at the recent snap elections; and high operational leverage of Japan Inc to synchronous global economic improvements.’ There are myriad reasons for our confidence in Japan’s economy.
Corporate governance reform
Topics of discussion with Japanese corporate management have shifted materially over the last decade towards long-term corporate strategy, principal-agency relationships, etc. This positive development has derived from the introduction of corporate governance reform two years ago, and has gradually helped increase the return on equity (ROE) for Japanese companies. We believe that better corporate governance will continue to help unleash the value that has been hidden within Japanese equities.
Two of the major objectives of the corporate governance incentives are: 1) to eliminate conflicts of interest that exist between management and shareholders, and; 2) to ensure that a company's assets are used effectively in the best interests of stakeholders. There is a positive correlation between the level of improved corporate governance and ROE in Japanese companies. Figure 1 indicates that the average ROE of Japanese companies was substantially lower than in the US and Europe in 2011, but the gap had narrowed noticeably by 2017.
Japan's Financial Services Agency proposed a 'Stewardship Code', which endeavours to promote sustainable growth in the corporate sector in addition to achieving fair investment returns for clients and beneficiaries. We are thus witnessing Japanese companies significantly raising dividends and initiating share buybacks. With total cash sitting on corporate Japan's balance sheet amounting to a record high of more than JPY 250 trillion ($2.3 trillion), it is likely that Japanese companies will continue to raise dividends, increase mergers and acquisitions (M&A), and complete further share repurchases to mitigate the drag of excessive cash balances on ROE.
Returning excess cash to shareholders or putting cash to work for investments is a reasonable management decision since cash balances earn a zero - or sometimes negative - return, after inflation. We believe that investors will reward companies that generate sustainable free cash flow, earn returns significantly above their cost of capital and regularly conduct shareholder-friendly capital management (such as increasing dividends, buying back shares, and pursuing accretive M&As).
Additionally, Japan's Government Pension Investment Fund (GPIF), the world's largest public pension fund with assets under management of approximately $1.2 trillion, has been starting to focus on Environmental, Social & Governance (ESG) oriented investments. Given the size of the fund and its influence in the investment community, GPIF's stance towards ESG will force Japanese companies to be increasingly aware of improving corporate governance as well as their social/environment behaviours. Corporate governance reform is not a single-year event, but an irreversible structural move, which should continue to be welcomed by equity investors.
Productivity is a far more critical concept for the Japanese economy and its corporate sector than simply high growth. Abe drove labour reforms forward with a goal of encouraging women and retired workers to return to work, increasing the rate of labour force participation.
The government's various efforts are starting to bear fruit: some 1.5 million Japanese women have been added to the workforce over the last four years and the female labour participation has risen to 68 per cent, up eight percentage points in the last 15 years, having caught up with the US, according to OECD data. Also, the total number of employed has increased by more than 2.4 million over the last four years.
Deregulation of Japan's labour structure is underway with the goal of increasing salaries and providing better career opportunities for non-fulltime workers. As part of Abe's structural reforms, the government introduced the concept of 'equal pay for equal work', called 'Hatarakikata-Kaikaku' with the aim of improving labour productivity. According to McKinsey's report titled "The Future of Japan: Reigniting Productivity and Growth", if Japan succeeds in doubling its rate of productivity, it could boost GDP growth to about three per cent and increase GDP by up to 30 per cent by 2025. Note that the Japanese government's goal is to increase GDP to JPY 600 trillion (currently JPY 546 trillion), or to $5.5 trillion, by 2020.
A belief among some is that Japanese companies are simply not competitive. This argument stems primarily from two assumptions: 1) that Japanese companies are not producing value-added products/services, and; 2) that Japanese companies are not pricing products/services appropriately (i.e. selling value-add at significant discounts).
With regard to the first point, the Atlas of Economic Complexity Index measures the extent of critical knowledge incorporated in an economy, implying the relative uniqueness of the products that are marketed to overseas trading. On this measure, Japan has been rated as the world's most complex economy every single year since the start of this data collection in 1995, which suggests that Japanese companies have continued to bring value-added products to market.
On pricing, there is huge room for improvement. The 'irrational behaviour' of excessive price discounts among Japanese companies was to some extent exacerbated by deflation, which plagued Japan for more than a decade, and also by excessively competitive market dynamics (too many competitors in the same industry). Although inflation has not reached the 2 per cent level targeted by the Bank of Japan yet, at least we can say that Japan was able to defeat deflation.
Also, data compiled by Nomura shows increasing M&A activity from 2010 to 2016, indicating industry consolidation has been taking place gradually but surely. Demographics come into play here as well. Given the ageing society, an increasing number of small business owners are starting to think about retirement.
Japan's small/medium enterprises account for about 99 per cent of its total number of companies, employ 70 per cent of the workforce, and have seen the average age of their presidents climb each year4 These businesses will continue to come up for sale, fuelling industry consolidation, and eventually increasing pricing power.
It can be said that Japan's elevated economic complexity over decades has been supported by high levels of patents and R&D. We believe that through its continued investments in future technologies, Japan should be able to maintain its leading technological edge across such industries as robotics, automation, games, specialty materials, and precision equipment.
Spotlight on inflation
Japan’s GDP has expanded for seven consecutive quarters, which is the best run in sixteen years. Japan’s nominal GDP is making a new high of JPY 549 trillion, the highest level in 20 years. In 2015, the Japanese government set a target to increase nominal GDP by 20 per cent to JPY 600 trillion, which is 8.5 per cent shy of its goal, as of Q3 2017. We think that GDP is on a sustained growth track supported by both structural reforms such as labour and tax reforms, coupled with the Bank of Japan’s (BoJ) accommodative monetary policy.
It is true that inflation hasn’t risen to the 25 per cent level which the BoJ has long targeted, but our on-the-ground research suggests that the Japanese economy is no longer deflationary, with food, taxi fares, office rent, delivery service and restaurants all seeing rising prices. Japan’s CPI has increased steadily over the past year, reaching +0.9 per cent YoY in November 2017.
In determining whether the economy has made an exit from deflation, the Japanese government has focused on four main indicators as shown in the four graphs below: 1) CPI, 2) GDP deflator, 3) unit labour costs, and 4) the output gap. All of these indicators are about to move into positive territory at the same time, the precondition for the official determination of the end of deflation. Until there are sustained positive readings from the four indicators at the same time for a few quarters, the accommodative monetary policy is expected to continue.
Given the changing inflationary environment, Japanese companies have started to review their strategies for selling products and services with proper pricing2 and not to cut prices simply to gain market share. This ‘normal’ pricing behaviour hasn’t been seen for quite a long time due to the entrenched deflationary mindset. This normalisation of price setting strategy should help buoy both revenues and profits, and further improve the margins of Japanese companies.
Attention is now being paid to wage inflation. We have seen some wage hikes in the lower income segment, but overall wage growth still looks anaemic. The word on Japan’s Main Street is that companies have excessive profits but retain it as an internal reserve rather than pay out to employees. Investors believe that companies do not pay out excess cash to shareholders, even though corporate Japan keeps more than JPY 200 trillion of cash ($1.8 trillion) on the balance sheet, with negative interest on a real basis. This is about to change.
As we will discuss later, Japan’s labour market is at its tightest historically, so that wage pressures should impact wage growth sooner rather than later. Japanese Prime Minister (PM) Shinzō Abe has promised to reward companies that raise wages more than three per cent. Taking into account PM Abe’s indicated expectations of a three per cent wage hike and public opinion, Keidanren (Japan Business Federation) will present specific policies for wages, and encourage debate between management and labour within individual companies.
Decisions on wage increases will be left to each company, but Keidanren will ask them to adopt a forward-looking approach to wage increases for the sake of the virtuous economic cycle and the reinvigoration of consumer activity.
Strength of the labour force
Japan is enjoying its longest run of labour force growth since the late 1990s, as the labour market continues to tighten. The job-to-applicant ratio suggests that there are 1.6 jobs available per job seeker in Japan – the tightest labour market we have ever seen. A key Abenomics success is getting more women into the workforce to lift household income.
The government’s various efforts are starting to bear fruit – some 1.5 million Japanese women have been added to the workforce over the last four years, raising the female labour participation rate (15-64) to 68 per cent, up 8 percentage points in the last 15 years, catching up with the US (according to OECD data). Also, the number of foreign workers has been rising, hitting the one million mark in 2016 for the first time ever. What’s interesting to us is the consistent increase in the number of foreign residents. It is true that PM Abe claims that the Japanese government is against any radical immigration policies, and it remains a controversial agenda in the homogeneous Japanese society.
However, stealth immigration seems to be underway, driven by the need to bolster the labour force. Immigrants as a percentage of total population is still much lower than in other countries, but its sustained uptrend reminds us of our history lessons – the ‘Convention of Kanagawa’ in 1854 (a treaty between Japan and the US) forced Japan to put an end to its national isolation that had existed since 1616.
Tax cut boon
Since the Abe administration came into office, the government has been lowering the effective corporate tax rate to make Japan more attractive for businesses. The overall effective corporate tax rate in Japan has fallen from 37 per cent in 2012 to 29.74 per cent effective April 2018. Additionally, Japan approved new tax measures to cut corporate taxes further to 25 per cent for companies that raise wages by 3 per cent, and to as low as 20 per cent for those that invest in new technologies.
The Japanese government is also examining the idea of slashing fixed-asset taxes to help small- and mid-size companies boost productivity. We believe that these conditional tax cuts should be positive for the economy and the corporate sector, as they will contribute to improving competitiveness and productivity. We think that these tax cuts should help to maintain Japanese business confidence for the time being, which is already close to the highest levels since the late 1980s.
No monetary tightening
Given the positive macro backdrop, some people are starting to think about probability of BoJ’s policy shift. Our view is that BoJ is likely to shift the target in its YCC policy (Yield Curve Control), allowing the Japanese Bovernment Bond (JGB) yield curve to somewhat steepen if growth continues to be strong and inflation is sustained.
When BoJ Governor Haruhiko Kuroda made a speech in Switzerland last November, he mentioned that most corporate and household financing is based on short- to medium-term interest rates, but longer-term interest rates are likely to be more relevant for society’s financial infrastructure functions such as insurance and pensions. He explicitly mentioned the ‘reversal rate’.
Academic research3 suggests that there may be a point where further interest rate declines are likely to do more harm than good to the economy. Nobody knows where that level is, but the fact that he referred to it suggests that BOJ is perhaps thinking that low shorter-term rates are more effective in stimulating the economy than low longer-term rates.
In fact, after years of massive asset purchases, BoJ’s data indicated total assets on its balance sheet slightly shrank from the end of November to December 2017, the first month-to-month decline since the initiation of QQE (Quantitative Qualitative Easing) as a part of Abenomics. This move would help the JGB yield curve steepen, which would benefit Japanese banks, insurance companies and pension funds.
The probability of tweaking the YCC policy is rising. We should bear in mind that shifting the target and letting the long end of the curve rise would not be a tightening move. Even though Japan appears to have turned the corner on deflation, we believe that BoJ will persist with powerful monetary easing to nurture positive inflation developments. Continuing accommodative monetary policy should be friendly to the equity market, and should help Japanese business confidence, which is close to the highest levels since the late 1980s, remain elevated.
As we discussed earlie,r corporate governance reforms are beginning to change Japanese companies’ mindsets into becoming more shareholder friendly – increasing returns on equity and returning excess cash to shareholders. Better corporate governance in Japan is still a work in progress, but companies are clearly making good progress.
We are witnessing many technologies and inventions emerging in Japan, supported by its researchoriented corporate culture. There are multiple ways for Japanese companies to enhance their competitive advantage and increase operating productivity. McKinsey's "Future of Japan" report claims that simply by adopting global best practises, deploying next-generation technologies, and organising for discipline and performance, Japanese companies can achieve at least 50 per cent of their productivity goal by applying practises that are already in use elsewhere around the world.