Global Recovery May be Favorable for Japanese Equities

Portfolio Manager Shuntaro Takeuchi shares his views on what he believes is helping Japanese equities power ahead and discusses how exposure to Japan’s market can increase diversification.

Japan’s new Prime Minister Yoshihide Suga took office in September 2020. What have we seen in terms of economic policy under the Suga administration?

Overall, the economic effects are neutral. On the positive side, Prime Minister Suga was a long-standing cabinet member under former Prime Minister Shinzo Abe, so the continuity of Abenomics policy remains intact. Due to COVID-19, the Japanese government has been more willing to expand its balance sheet. The Bank of Japan has remained in an accommodative monetary policy stance since 2013, and now fiscal policy is changing after having been characterized by austerity in recent years. The supplemental budget from the new administration will likely be one of the world’s largest in terms of percentage of GDP.

On the negative side, Suga’s approval rating has declined faster than I initially expected, partly due to an increase in COVID-19 cases at year-end 2020. While Japan is managing the pandemic better in our view than many other countries, domestic media are criticizing Suga as being late to introduce a state of emergency.

What’s driving Japan’s equity markets today?

First, Japanese equities may be poised to benefit from a global recovery due to their exposure to global industrial production. More than 50% of the MSCI Japan Index is in three sectors: industrials, information technology and consumer discretionary, which includes automotive companies. These sectors tend to do well when economic growth bottoms out then starts to improve. As we see in the J.P. Morgan Global Manufacturing PMI (purchase manager index) numbers, activity bottomed in April 2020 at 39.6 and recovered above 50 in July 2020. Japanese equity multiples expanded during this period.

Second, despite the multiple expansion, Japanese markets are still trading at discounted valuations compared to other developed markets. The price-to-book ratio of the MSCI Japan Index fell below 1.0x in March 2020, and, even with the recovery in the second half of 2020, it is now approximately 1.5x. By comparison, the MSCI Europe Index is currently trading at 1.97x and the MSCI Asia ex-Japan Index at 2.26x, with the S&P 500 Index at 3.97x.

Third, global investor flow is coming back to Japan. Despite excitement around Abenomics, global investors have been continually reducing Japanese equity exposures in recent years. In the last few months, however, this trend has started to reverse.

In the past, Japan was often associated with being a value market. Today, innovation is a bigger driver. Where are you finding growth in Japan today?

Japan was indeed a value market for a long while, but the dynamic has changed in the last decade. I believe this change is being driven by innovative growth companies which provide solutions to many of the mega-trends evident in Japan and worldwide.

One such trend is related to demographics, specifically, declining populations. The pace of decline in Japan is currently more than 400,000 annually, equivalent to a mid-sized U.S. city. The labor population is shrinking at a faster speed. We see opportunities in areas that counter population declines by enhancing productivity, including automation, software, IT services, fintech, and business process outsourcing.

Another trend is a rapidly aging society. With 28% of Japan’s population age 65 and older, what is an issue now in Japan will be a global issue tomorrow for many countries. Here the agenda is to control health care cost inflation. We see opportunities for long-term growth in areas like pharma, bio tech, medical devices, and cost-reducing health care services.

We also see opportunities related to environmental change. Because Japan lacks natural resources, many industries in the manufacturing sector provide solutions for the efficient use of resources. Areas of growth include semiconductor capital equipment, electronic components, electrification, and material sciences.

What risks are you monitoring among Japanese equities?

While the percentage has declined over time, a meaningful portion of Japanese corporate profits still come from export sectors. Right now, the global export sector is in recovery mode, but a slowdown in the recovery would be a risk for Japanese markets. Also, commodity inflation in manufacturing activity could pressure margins. We closely monitor the risk of unintended inflation, especially in Japan, where natural resources are driven mostly by imports.

For investors seeking diversification, what is the case for adding exposure to Japan today?

Compared to Japanese markets, European equity markets typically have higher exposure to financials, energy, and materials, while Japanese markets are more exposed to technology, industrials and consumer discretionary. If you believe we are in a structural rising rate environment and commodity consumption boom, then maybe European markets will do better than Japan. However, we think the world—especially the developed world—is consuming fewer resources, particularly as the population is peaking and aging. We prefer to invest in, for example, an auto company that works relentlessly to be more efficient and consume less energy, instead of investing in an oil major.

Shuntaro Takeuchi
Portfolio Manager
Matthews Asia