It was all over the headlines, but has since disappeared – what’s happening to Japan’s economy now?
Since the March earthquake, the Japanese economy has plotted a v-shaped recovery as supply-chain disruptions were quickly resolved and manufacturing facilities were brought online ahead of schedule. Production normalised in most industries and sentiment indicators rebounded.
As a result, Japan has recovered well and the prospect of a third supplementary budget and substantial reconstruction demand should also prove quite helpful for growth in the future.
However, while domestic supply-side constraints have eased, external demand factors have deteriorated, slowing the pace of Japan’s recovery and impacting negatively on stock performance. Following the strong rebound in the third quarter (the consensus forecast was for annualised real GDP growth of around 6.0%), economic activity is expected to slow in the coming months, with structural fragilities in Europe and the US, as well as fresh supply-chain disruptions stemming from the floods in Thailand, representing key risk factors.
Meanwhile, the strength of the yen is also a major headwind for the Japanese market, fuelling concerns about the outlook for corporate earnings, especially at export-oriented firms. Japanese authorities have intervened in the currency markets and implemented additional monetary easing, but yen strength appears likely to persist in the absence of concerted action. Despite the strength of the yen’s rise against the dollar and the euro, it is worth remembering that the real effective yen rate, a measure of Japan’s competitiveness, is actually still well below its 1995 peak.
Corporate Japan remarkably resilient despite headwinds
Despite headwinds, at the microeconomic level, Japanese companies have seen a significant improvement in earnings and profitability. They have strengthened their earnings base, improved cost efficiencies and appear to have become more accustomed to coping with persistent yen appreciation. They have also increased their overseas presence, particularly in Asia, adapting to sluggish domestic demand and structural shifts in the global economy (eg. emergence of Asian and other developing economies).
Meanwhile, cash reserves at listed Japanese companies have risen to record highs and free cash flow generation has improved significantly. In addition to enhancing shareholder returns through buybacks and dividends, companies have wisely been seeking to capitalise on the strength of their balance sheets and the yen to acquire businesses overseas. This strategy has been supported further by the recent expansion of the government’s foreign investment loan programme, which is aimed at curbing yen strength by getting Japanese companies to increase their foreign currency assets. In the first six months of fiscal 2011 (April-September), Japanese companies made ¥3.1 trillion of overseas acquisitions, a 130% increase on the same period a year ago.
The re-emergence of corporate governance issues
Recent scandals at Daio Paper and Olympus have raised some concerns about corporate governance in Japan, threatening to further cloud investors’ view of the domestic market. With overseas investors accounting for almost 70% of stock trading in Japan, a feeling of distrust in Japanese firms could further thin trading volumes.
While these recent cases have understandably raised doubts about the transparency of management, it is important to remember that they relate specifically to individual companies and are not reflective of corporate Japan as a whole. Indeed, over the past ten years or so, a significant shift in Japan’s shareholder base has helped to increase pressure on management to improve governance and enhance shareholder value.
An oft-cited limitation of Japan’s corporate environment in the past was ‘keiritsu’- an economically inefficient system of tight inter-corporate linkages (the Japanese word literally means ‘headless combination’) built around cross-share holdings between groups of companies. However, this particular driver of potential corporate malfeasance is much less relevant today because the cross- shareholding ratio (the ratio of holdings of other listed companies by listed companies on a market value basis) has fallen from around 33% at the start of the 1990s to a record low of 11% (as of 31 March 2011). At the same time, the ratio of Japanese shares held by overseas investors has risen from less than 5% to around 27%, something which is supporting the adoption of western corporate governance norms.
Furthermore, it is reasonable to say that Japanese companies have improved their organisational structures and decision making processes more generally. As a result, they are far better placed to respond quickly to changes in the economic environment and/or their respective industries. A recent example would be Panasonic’s decision to downsize its mature and loss-making businesses, and to focus more on new growth areas such as high-margin energy-efficient household appliances.
Cheap across the board- but selection still the key
Japanese equities now look extremely cheap against a wide range of measures. The market is not only cheap relative to its own long-term history on asset and earnings based metrics like price-to-book and cyclically adjusted price-to-earnings ratios (also known as ‘Shiller PE ratios’) – it is now cheap on a global sector-by-sector basis. Analysis from Deutsche Bank shows that Japanese equities were the most expensive in the world on a sector-by-sector basis 100% of the time in the late 1980s. However, in the intervening years that premium has reversed to the point where, now, Japanese sectors are the cheapest in the world 60-70% of the time.
Another way to assess the valuation of stock markets is to look at the ‘equity risk premium’ (ERP). This is calculated by deducting the current 10-year domestic bond yield from the expected return of a given equity market. As the chart below shows, Japan has a current ERP of 4.9%. This is lower than what’s currently available in China and the UK for example. However, a better gauge of value is gained by looking at past numbers for the same market. Doing this reveals that Japan’s ERP looks very favourable, with the widest positive differential versus its historical average out of all the major global equity markets. Indeed, this leads Soc Gen to make the notable conclusion that, ‘relative to Japanese government bonds’ the Nikkei appears to be the cheapest (main) market in the world compared to its historical norm.
All this said, investors need to be aware that cheap markets do not always equate to value, because often low valuations are fully deserved. The key then is to be very selective and to seek out those quality companies that are well managed but about which the market, for whatever reason, has become unjustifiably negative. Such instances are comparatively rare, but in the current environment of overall investor nervousness, we believe they certainly do exist.
Conclusion – a stock-picker’s market
While macroeconomic issues continue to mask a healthy corporate sector in Japan, Japanese equities remain underappreciated by investors.
Over the past 10 years, Japanese companies have strengthened their earnings base, enhanced cost efficiencies and improved free cash flows. Despite some recent negative news stories, a shift in the composition of shareholders has actually contributed to improvements in governance and shareholder returns. Furthermore, the Japanese market has finally worked off its valuation premium and now compares very favourably with its own long-term history and its global peers on virtually all main measures.
Over the medium term, a combination of solid corporate fundamentals, more shareholder-friendly activity, historically low valuations and poor sentiment is likely to provide a very favourable backdrop for stock selection in Japan.
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