Japan: Leading Inflows and Search for Quality

• Shirley Low-Storchenegger, Head of Asia/Pacific
  

Following years of underperformance and investor apathy, Japan is emerging as a favorite market for many. According to data from Bank of America Merrill Lynch and EPFR Global¹, inflows into dedicated Japanese equity funds have this year topped money going into US and Europe funds.

Much of the interest rides on two factors. On the one hand, Prime Minister Shinzo Abe’s government has introduced transformational policies aimed at enhancing the corporate governance and shareholder returns of the country’s companies. Secondly, the Bank of Japan has boosted its fight against deflation, raising optimism that consumer prices – and demand – may come out of years of stagnation.

I talked to Maromi Oike, senior strategist at Mitsubishi UFJ Trust and Banking Corp. (MUTB) in Tokyo. Her views on the outlook for Japan’s economy and equity markets appear below.

STOXX has a two-year old alliance with MUTB. The iSTOXX® MUTB Japan Quality 150 Index was the first co-branded smart-beta benchmark produced by both partners, and it provides exposure to Japanese companies with high profitability, low leverage and sustainable cash flows.

Four years have passed since Prime Minister Shinzo Abe introduced his policies aiming at reforming the economy. What has been accomplished since then?

Despite the fact that it is not difficult to find critics who assess ‘Abenomics’ is doing little in practice, and those who still see Japan as a big question mark, there has been slow but ongoing progress.

Profits for Japanese companies have grown to a record high. Regular wages, which had long been subdued or even declining, have finally picked up. The ratio of increasing items in Japan’s CPI (inflation) indicator is now roughly 70%, compared with 49% before Abenomics. Japan is also becoming one of the top tourist destinations. These are just some of the changes that our country has witnessed over the past four years. Yes, the pace of change has been much slower than policymakers had originally expected, but changing the mindset of a country that was trapped in deflation for more than a decade is not easy. Yet, things are moving.

What other reforms should we expect?

The area the government is currently focusing on is the labor market – in particular, the way people work. Some large companies have already started to tackle the issue of long working hours by promoting increased telecommuting and working from home, or introducing 4-day work weeks. But in a country like Japan, identified as the world’s most workaholic nation, more needs to be done. ‘Equal pay for equal work’ has also been marked as a top priority, together with increased female participation – reforms otherwise referred to as ‘womanomics.’

There are demographic and fundamental issues holding back Japan’s potential growth rate. Can the country come out of what has been a long period of tepid-to-nil economic expansion?

The period that some have called ‘secular stagnation’ may be something of the past. Nominal GDP has risen by over 9% since PM Abe took power – a level Japan had not seen for 20 years.

For a country that faces the double headwind of a declining and ageing population, expecting a persistent 3% to 4% growth rate is not realistic. But in order to fight the issue of demographics, Japan has chosen to receive more foreigners and to speed up investment in Information Technology. An ageing population is not unique to Japan. In that sense, many developed countries will be following on the footsteps of Japan’s experience over the next decade. Back in the 1980s, it was Japan’s strong birth rate that provided labor to fuel the dominance of the country’s auto sector. This time round, it could be Japan’s graying society that may fuel the resurgence of our economy.

A key variable for the development of Japan’s economy is the value of the yen. The currency has weakened significantly in the past four years; but is it yet at levels that can stimulate exports?

Yes, the currency has weakened significantly over the past four years but a large part of it has been a correction of the excessive appreciation of previous years. Although more clarity on US policies is needed for the yen to weaken further against the dollar, with the Fed looking likely to start their balance-sheet normalization as early as the end of this year, the US-Japan bond yield gap will widen. This will push the yen lower against the US currency. Dollar-supportive repatriation flows should speed up the move. This will stimulate exports.

Japanese equities have notoriously underperformed global indices for the best part of three decades. Could that be about to change?

A prolonged period of low economic and earnings growth was the major reason behind that underperformance. But now that growth is coming back, Japanese equities have the potential to outperform, as has already been the case in some of the years since the implementation of Abenomics.

The fact that long-dated yields in Japan will be capped at around 0% will also provide support for Japanese equities, as bond markets could face a global sell-off amid possible policy normalization from major central banks.

One of PM Abe’s ‘three arrows’ targets reforms in the country’s corporate culture, introducing policies that reward corporate governance, return on equity and shareholder-friendly activities. Will that be a driver for equity returns?

Improved corporate governance has been one of the key factors that have attracted foreign investors to the Japanese equity market. Over the past two to three years, Japanese firms have worked hard to boost corporate value. There has been a dramatic increase in share buybacks. The number of companies with independent directors has jumped. More companies have disclosed policies on shareholder returns. Fundamental changes are happening at the corporate level, leading to higher ROEs and faster earnings growth. All which means greater equity returns.

Those corporate attributes are in line with the ‘quality’ factor used in the iSTOXX MUTB Japan Quality 150 Index. What performance characteristics are to be expected from tracking ‘quality’ companies?

According to our analysis, as return on equity improves, evaluating stocks by their profitability becomes more important. And focusing on sustainability of profitability leads to higher returns than just focusing on profitability itself. The iSTOXX MUTB Japan Quality 150 Index aims to achieve an excess return by keeping the growth rate, or return on equity, high. Since the index has a high price-to-book value characteristic, it tends to underperform the market when cheap stocks outperform, such as in turnaround phases. On the other hand, it tends to outperform the market in times of moderate growth and in downward markets.

Finally, last year’s victory of US President Donald Trump has raised fears of a new protectionist world order. Do you feel that is the case, and what does it mean for Japan?

Japan currently accounts for less than 10% of the US trade deficit, compared to the highs of 65% back in the 1990s. But still, President Trump has been critical of what he describes as an unfair trade in that the number of American cars sold in Japan is far less than the number of Japanese cars sold in US. True, auto and auto parts account for roughly 70% of Japan’s trade surplus with the US, but it is also true that the volume of auto and auto parts that the US has imported from Japan is on a declining trend. Japanese consumers are willing to drive imported cars but they have to comply with local tastes and needs.

We would also watch closely any trade clashes with China, the world’s largest manufacturing assembler. A trade war with the US would have a knock-on effect on all Asian economies that supply high-value added parts – including Taiwan, Korea and Japan.

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iSTOXX MUTB Japan Quality 150 Index 

¹ “The Flow Show,” Bank of America Merrill Lynch, May 18, 2017.