Japan: What is the Outlook for 2018?

In a nutshell, why do you like Japanese equities?

The Japanese equities market is one of our favourite equity markets for 2018 thanks to the sustained global synchronous growth and its very pro-cyclical nature.  The Japanese index (Topix) is essentially made up of cyclical stocks: 22% industrials (15% capital goods), 20% discretionary consumption (10% auto) and 13% technology. Banks account for 12%, ranking them in 4^th position. Consequently, Japanese indices are overweight in cyclicals (15%) compared with global indices.

So the macro economy is an important factor for you. Could you describe the economic climate in Japan?

Japan’s gross domestic product (GDP) reached a nominal level of JPY 550 trillion in this year’s third quarter. It was only in the first quarter of 2016 that it finally exceeded the level reached in the fourth quarter of 1997 (JPY 536 trillion). For two decades, Japan suffered from various factors: deflation (since 1993), characterised by an output gap which was barely positive between 1992 and 2002 – and different shocks in demand, such as the Asian financial crisis of 1997 and the burst of the dotcom bubble in 2000. Observers often speak of secular stagnation due to structural effects such as the ageing population and chronic underinvestment.

The re-election of Shinzo Abe in December 2012 ushered in a new era of an acceleration in economic growth. Nominal GDP rose from JPY 501 trillion to JPY 550 trillion, thanks to the so-called “Abenomics” policy which has three main parts:

• FISCAL MEASURES: Spurring the economy through large-scale plans, contrary to prevailing austerity in the rest of the world.
• MONETARY MEASURES: Injecting massive amounts of liquidity to facilitate credit, diminish the cost of lending and stimulate business investment and household consumption. This policy includes buying sovereign debt over the long term. This new monetary strategy, similar to the one pursued by the Federal Reserve since 2008, is a real turning point for Japan’s monetary policy.
• STRUCTURAL REFORMS: Implementing several structural projects to deeply transform the system and increase Japan’s “growth potential”. Firstly, the public authorities encourage foreign and women workers to adapt to the ageing population. The number of foreigners on Japanese soil rose by more than a million between 2012 and 2016 (but the phenomenon concerns very specific jobs: services such as childcare and care for the elderly).  Secondly, there are deep changes to corporate governance; companies are adopting a new code of conduct in a bid to make the system more efficient. The aim is to increase companies’ return on equity (RoE) and profit margins.

The “Abenomics” policy is deemed positive overall. Beyond the acceleration in GDP growth mentioned above, we note a moderate recovery in consumption, even if the ageing population and tax increases (8% VAT in 2014) had a negative effect while the yen’s depreciation between 2013 and 2014 squeezed the purchasing power of the Japanese people.  We highlight that tourism has been driving demand.  Moreover, recently, exports have started to underpin Japanese growth. Secondly, investment spending has been sustained, particularly in construction, real estate and the public sector. Finally, the increase in investments can be explained by an expansion in tourism (hotels) and low rates (real estate and public spending).

Prospects are good. In 27 years, economic conditions have never been so good, according to a quarterly Tankan survey. Admittedly, the “output gap” is positive and investment demand is underpinned by infrastructure needs linked to the 2020 Olympic Games that Japan will host.  Consumer confidence has also reached highs, thanks to an unemployment rate below 3% and a wage increase, albeit very modest for the moment.   International trade is still on a good track and Japanese exports should benefit from the expected weakening of the yen.

What is the role of politicians?

The political climate has been comforted by Shinzo Abe’s recent landslide victory in the snap elections. Moreover, Mr Abe should be re-elected president of the Liberal Democratic Party (LPD) party next September. This will pave the way for him to secure power until 2021. We will be watching any developments/changes in the constitution which might weigh on the political climate in the short term. Indeed the prime minister wants to step up military spending while the Japanese people are against. His obstinacy might dent his popularity.

Moreover, a new governor and two deputies of the Japanese central bank are expected to be appointed in January. We do not foresee any changes in the Bank of Japan’s policy following these nominations.

Why do you remain positive on Japanese equities?

Five factors support our positive view.

• The first is the macro-economic context described above. It points to a rise in bond yields, an important condition for an attractive performance of the Japanese stock market (correlation of 0.74 since 2000).
• The second is monetary policy, which is expected to be accommodating over the long term and which will support the erosion of the yen.
• The third is our expectation of a favourable earnings trend. A good sales momentum, ongoing efforts to improve margins and return on equity, a weakening of the yen and share buybacks (which will remain very strong) will drive a favourable trend in earnings and revisions.  Moreover the dividends payout rate is set to rise: for the moment it is the lowest among main equity markets.
• The fourth factor is valuation metrics. The prospective PE (price-to-earnings) of 15x prospective earnings is 10% below the PE of the global equity markets.  The price to book value (1.4x) compared with 2.3x for the global equity index. The risk premium is also very attractive.
• The fifth supporting factor is the positioning of investors who remain underinvested. Japanese households only hold 9% of their investments in equities versus 53% in cash. Foreigners have a lower exposure than benchmark indices.