Are you among the masses of investors who have either lost money or underperformed by putting faith in Japanese equities?
Since the end of 1990, the TOPIX Index has annualized a whopping –1.96% through August 2013 in yen terms, trapping investors as it brutally dished out 15 different head fakes and false starts.
No wonder Japan is arguably the most disliked developed market to invest in among both retail and institutional investors around the world. It has not been uncommon to see mid- to high-single digit country weightings allocated to Japan among some of the largest mutual fund managers in the United States, relative to the benchmark weighting of 22% in Morgan Stanley Capital International’s EAFE Index.
So, given the Japanese stock market’s less-than-appetizing track record of deception, how should you interpret all the glamor and hype over the nation’s current economic rebound and high aspirations of political reform? Is it possible that Prime Minister Shinzo Abe is in fact the rainmaker and that his so-called Abenomics is the true path to the promised land? Perhaps. But consider also that TOPIX is already up roughly 60% from mid-November 2012. How much more upside is left for those who missed out on this flash rally?
The answer, plain and simple, is: plenty.
No Pain, No Gain
This phrase comes from 17th-century English poet Robert Herrick’s poem “No Pains, No Gains.” This concept was later adopted as simply “no pain, no gain” by aerobics guru and workout video star Jane Fonda.
So, just as millions of overweight viewers realized that only through a painful workout does true cardio advancement occur, Japan is striving to achieve badly needed economic advancement after its own horrific version of pain and suffering. On 11 March 2011, a mega-thrust earthquake off the east coast of the Tohoku region hit Japan head on with a force reaching 9.0 on the Richter scale. This earthquake triggered the Fukushima Daiichi nuclear disaster, which was categorized as Level 7 on the International Nuclear Event Scale, the largest since Chernobyl in 1986.
With several of the nation’s key manufacturing facilities out of commission and 27% of its electricity stripped away, Japan’s economy faced one of its darkest moments in modern history. To add fuel to the fire, the yen strengthened relentlessly as global economic fears drew investors to safe haven currencies. Logically, this foreign exchange appreciation delivered a severe body blow to Japan’s export-dependent economy.
South Korea, which has an extremely similar export-led economy composed of technology, automobiles, and industrials, was more than happy to step in for the knock out as they snatched away market share from their weakened rivals. From a political standpoint, Japan would soon lose its 61st and 62nd prime ministers, who voluntarily resigned after being exposed in repeated scandals and having approval ratings that hovered in the 20s — but this “pain” by itself would not have been much out of the norm.
So, That’s the Pain… What About the Gain?
How did Japan react to the terrible hand it was dealt? Ask for a reshuffle? Not quite. Japan took a moment of silence, regrouped, and began rebuilding at a fast and furious pace. Soon, Japan restored its production capacity, upgraded its infrastructure, and brutally cut costs until its corporate cost structure became leaner and more competitive than ever before. The nation was genuinely ready to take advantage of any uptick or favorable turn of events. Lo and behold, that is exactly what happened.
In the fourth quarter of 2012, the US economy finally began showing concrete signs of stabilization driven by an emerging housing recovery, while the Federal Reserve, led by Ben Bernanke, started its third quantitative easing program (QE3). Meanwhile, back in Japan, Prime Minister Abe finally took a page out of Bernanke’s book and decided to introduce a legitimate money printing program of his own, a key component of the Abenomics initiatives.
To seal the deal, in July 2013 the Liberal Democratic Party’s (LDP) coalition won 71 seats in addition to the 59 seats it already held, surpassing the 122 seats needed to control the Upper House. With both houses of the Diet now under the control of Abe and the LDP, a new era of strong leadership and political unity may actually come to fruition. Admittedly, the LDP coalition does not have a super majority that is required to call for a constitutional revision, but it has succeeded in ending the parliamentary gridlock in Japanese politics. To add even more icing to the cake, Tokyo has recently been selected to host the 2020 Olympics.
With global meltdown fears subsiding and a credible Japanese QE program in place, the yen soared from a low point of ¥77 to ¥100 in a matter of months. The overall economy swelled to grow 3.8% sequentially in the second quarter, Tokyo condo sales are up 53.3% year-over-year in August, and deflation is at last showing signs of stabilization. Perhaps the most important outcome of Abenomics is the simple but meaningful shift in mindset away from deflation and toward true inflation.
So, where do we go from here? This “gain” is all wonderful, but so is a 60% rally in equities, isn’t it? Yes, but maybe not after you consider the following. Amazingly, even after the huge market run, roughly half of all Japanese stocks are still trading below book value, which is a similar level shared by Greece’s stellar equity markets. Compare this with the United States, where less than 15% of its companies trade below book value. From a historical standpoint, this difference is easily explainable because Japanese companies generally have had low returns on capital and overcapitalized balance sheets because of the nature of a prolonged, ultra-low interest rate environment. But again, this just means there is more room for upside if this environment is to change going forward.
A simple supply and demand analysis also points to a similar conclusion. Along with the vast majority of investors around the world, the sharp rally in the TOPIX has left many Japanese corporations in the dust, with record amounts of cash still on their books unspent. This buildup of cash is understandable because holding cash has been a reasonable strategy over the years, given its superior real rate of return during times of deflation. According to a recent article, the amount of cash held by private Japanese companies grew 5.8% year-over-year in the first quarter to reach ¥225 trillion, the highest amount ever recorded. In addition to this mountain of cash held by the corporate sector, Japanese households have hoarded even more, registering at roughly ¥656 trillion.
That is a lot of cash that is generating a painfully negative real return for its owners as equities soar before their eyes. Let’s take a step back and compare this with the entire market capitalization of the Tokyo Stock Exchange, roughly ¥300 trillion. It is easy to see that only a fractional adjustment made to the balance sheets of Japanese households and corporations would have a significant impact on the equity markets.
Clearly, no rally is immune to risks. There is currently a spirited debate over the impact of a hike in the national consumption tax from 5% to 8%, which is scheduled to occur in April 2014. After all, a massive government money-printing frenzy does not come cheap. Although there is no way that the ¥8 trillion in annual consumption tax revenues will come even close to putting a dent in Japan’s ¥1 quadrillion debt balance, the initiative serves as an important and symbolic first step in addressing the ongoing structural problem.
Managing the implementation of this tax hike will be a delicate balancing act that Abe must execute with proper care and acumen. If the tax is implemented too aggressively with no meaningful offsetting factor (i.e., a corporate tax cut), it could damage economic sentiment significantly and derail any hopes of a sustained economic recovery. This concern is very valid because the last time Japan raised its consumption tax from 3% to 5% in 1997, consumption indeed contracted sharply and the economy fell into a recession soon after. So far, Abe has only announced a pathetic, one-time ¥5 trillion stimulus package that the market is not impressed with. On the flip side, if no consumption tax hike is carried out at all, the JGB (Japanese Government Bond) markets will have a seizure as global confidence in the government’s solvency would take a fatal blow.
The most rational path that Japan needs to take is to continue revitalizing its economy with stimulus that feels sustainable in nature while convincing the bond markets that the tax hike is on its way. This balancing act must occur long enough for the economy to gain enough real economic momentum to propel Japan into an “autopilot” recovery phase that can weather a tax hike, even if it means delaying the implementation date if necessary. In this hypothetical scenario, the JGB markets may rattle around initially on the news, but they will eventually forgive and forget a mere delay in the timing of a tax hike in the big scheme of things. Given Abe’s seemingly upgraded ability to jawbone political optimism to the public, coupled with the LDP’s coalition partner, the New Komeito party, apparently with him on this issue, there is a decent chance that both bond and equity markets actually get what they were looking for.
Most importantly, after two decades of losses, deflation, and disaster, the people of Japan seem determined to make a sustainable change for themselves. They have gone through pain and ruin, yet they have risen more competitive and revitalized than ever before. With the yen as a tailwind, unified government, renovated corporate cost structure, and gazillions in cash still waiting to be deployed, the stars finally seem to be aligning for a major breakout in Japanese equities. Still having doubts that this could be another one of Japan’s signature head fakes? Still can’t get around the fact that the market has already rallied 60%? Consider what happened to Japan post-World War II. From 1946, the TOPIX rose an annualized 14% for the next 25 years, or 1,284% in absolute terms, and the real economy expanded tenfold. Clearly, it is a different situation this time, but you do not want to risk being left behind during one of the few moments in history in which Japan really nails it. Keep an eye out, world. The sleeping giant may have just woken.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.