Japan is engaged in extremely aggressive monetary policy in the hopes of facilitating structural reforms in an economy that has stagnated for over two decades. There is a common belief that the Japanese equity market is rallying because international investors are trading into stocks while shorting the yen simply to take advantage of Japan’s QE program. Our Director of Research, Brendan Connor, recently returned from Tokyo with a fundamentally different impression and discusses the drivers and opportunity set in Japan today.
Thoughts on Japan
I recently spent a week in Japan meeting with a number of investment managers and business contacts. We discussed changes in the country which, upon further reflection, may seem less obvious to the outside world. This was confirmed in several meetings after I returned, where investors with some interest in Asia seemed completely unaware of the policy changes that have taken effect in the past several quarters. This is exciting stuff. Investors are clearly aware of Japan’s massive quantitative easing program and its effect on asset prices, but in my view, there are further nuances to this policy, and its channels, which investors have yet to fully appreciate.
Japan is not a place one considers ripe for rapid change. Over the past twenty years, Japan has been unable to sustain any significant economic reforms, generate growth, or keep a government in power. Since 1989, the average Japanese Prime Minister held the office for 560 days, with a median term of office of 418 days. Those figures drop materially if you exclude Junichiro Koizumi of the Liberal Democratic Party who held office for 1979 days. There have been five Prime Ministers in as many years since 2009! Returns on equity for Japanese equity markets have been among the lowest globally, while equity multiples reflect decades of mired performance. This was status quo in the memory of institutional investors globally.
Japan is rooted in tradition. Its people are strictly adherent to that system. It has been emphasized to me time and again that one should never underestimate the willingness of the Japanese population to endure great suffering in the name of the greater good. Today there exists a huge disparity between the wealth of aging pensioners and Japan’s youth. This is in large part a function of the Japanese employment system, which makes it terribly difficult to lay off workers and promotes on the basis of seniority rather than merit. This has contributed to a prolonged period of stagnation. It may, however, similarly facilitate its capacity to enact change at a rapid pace. My impression is that this may be occurring today on two fronts in a highly symbiotic fashion: economic reforms coupled with long-term geopolitical goals.
The geopolitical tensions are a subject for some controversy. It is no secret that China and Japan continue to play a very dangerous game in contesting territories in the sea which divides them. The historical animosity rooted in the atrocities of World War II have yet to be addressed on either side of the East China Sea. What’s more, these historical tensions are frequently stoked by both parties in order to ignite nationalist sentiment. I studied this extensively in my academic career. My original thesis that the lack of a mutual (or regional for that matter) understanding and acceptance of the events which transpired in the middle of the 20th century has heretofore hindered any progress in reaching a more constructive dialogue around sensitive geopolitical issues. It is notable how firmly both Japan and China assert that their regional geopolitical goals are not territorial or expansionist, despite how obvious it is that they are both trying to assert influence in the region.
I only discuss the geopolitical question in this note because I believe it is important to emphasize in the context of why these policies are being enacted as aggressively as they are. It is a matter of Japan re-establishing itself as a base of power in the Pacific, and it is actively expanding the scope of its so-called “Self Defense Force.” Military expenditures represent 1.0% of GDP in Japan, versus 2.1% in China, but ranks 7th globally in U.S. dollar terms at $47.7 billion versus $129.4 in China. It is my strong impression that Japan’s domestic agenda is a means to its international aspirations. Those aspirations are martial, hegemonist, territorial, and directly counter to Chinese interests in the region. All are very bold statements, but are hard to dismiss given the evidence. It should also be stated that the Japanese and Chinese authorities have and will dismiss those points outright.
Why this matters is that relative to prior Japanese experiments with alternative monetary policies and fiscal reforms, which all fell flat on their face, the current experiment is backed by a mandate and level of commitment to change that we have not witnessed in the past. This implies that investors who are focused simply on the capacity of quantitative easing to stimulate equity markets have missed the bigger picture both in terms of the scope of that policy and the likelihood of success of the “Third Arrow” or domestic reforms aimed at stimulating growth.
The most recent example of this change, which we find very exciting, is the new policy demanded by the Nikkei for companies to set intermediate and long term plans; they must be transparent with investors regarding those plans, set targets for return on equity, and actively engage with shareholders. This is an absolute about-face when you consider the low returns and high cash balances Japanese companies have historically achieved. Where Japanese companies previously held large baskets of cross shareholdings of other Japanese equities for allegedly “strategic” purposes; now they have to be explicit as to the specific strategic purpose those shares serve. Furthermore, if they do not follow this policy, they risk having their shares delisted. The Nikkei is also rolling out a new stock index which is based purely on returns on equity. We used to call Japan the “greatest exporter of value traps globally.” Now domestic asset managers are required to develop engagement programs to interact with managements – the government has mandated that both companies and shareholders wake up to the new political reality.
Too often we have heard foreign investors argue that the story of the Japanese equity market was purely that of the yen. Yes, the two have been highly correlated since this policy first went into effect in 2012. This would imply that investors are massively short the yen and investing in Japanese equities. We take the other side of that argument. Of all the people we speak to who allege that investors are somehow overweight Japan, we have yet to speak to one foreign shop that actually is overweight Japan!
Our view is that it is domestic investors’ activity which has precipitated the rise in the Japanese market. The Bank of Japan’s quantitative easing program has served to rebalance Japan’s government pension system – from a paltry weight in equities, out of Japanese Government Bonds, and now to some 20% in equities. Japan Post which will IPO this year is expected to carry out a similar move. They have been purchasing dividend stocks aggressively, which is reflected in those stocks’ valuations today. Still, the valuations on mid and small cap equities are extremely attractive, and they will likely be next to follow suit.
We continue to see returns on equity on the rise, and the Government in coordination with the Bank of Japan appears, for the time being, dedicated to achieving its inflation targets. If that is the case, there will be more QE in the future and more activity for active investors to take advantage of. Of course, we must acknowledge that there are significant risks to this position. The success of these reforms is up in the air. The ability to drive further stimulus through QE is being actively questioned within Japan, and the militarist rhetoric may simply backfire. Still, following years of stagnation, the setup for the Japanese market is very enticing.
To view the memo as a PDF, please click here: Thoughts on Japan
About the Author
Brendan Connor is a member of Hillview’s Investment Committee and responsible for leading their research efforts, including strategy and manager research, risk management, due diligence and monitoring.
Mr. Connor has a B.A. in East Asian Studies from Hamilton College and was the recipient of the Freeman Foundation Grant for Research in Sino-Japanese Historiography. He studied Chinese with the Associated Colleges in China at the Capital University of Business & Economics in Beijing. Brendan is a Chartered Financial Analyst (CFA) charter holder.
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