Making sense of Japan’s economic and political developments
Japanese equities have been very volatile in recent months.
Initially this was driven by the diverging monetary policies of the US (interest rates down) and Japan (rates up). This prompted a rapid unwind of Japanese yen ‘carry trades’ (where investors borrow in yen and invest in higher yielding foreign assets) and a sharp currency appreciation. More recently, uncertainty around Japanese politics and the announcement of a snap general election exacerbated this volatility.
We spoke to Masaki Taketsume, portfolio manager of Schroder Japan Trust plc, about these short-term challenges and how they may impact the long-term outlook for Japanese equities.
The market has seesawed during the process of electing a new prime minister and the general election – can you give some context for these moves?
Markets were initially unnerved by the unexpected victory of Shigeru Ishiba in the run-off with Sanae Takaichi to become the next leader of the ruling Liberal Democratic Party (LDP) and Japan’s next prime minister (PM).
This prompted a reversal of the so-called ‘Takaichi Trade’, in which we had seen a weakening yen and rising stock prices in the last few days of September. Takaichi had been viewed very much as a continuation candidate that had long been aligned with the ‘Abenomics’ policies and ideals of former PM Shinzo Abe.
By contrast, Ishiba is known as a fiscal reformist and had been considering an increase in capital gains tax, so his victory was initially greeted more cautiously by the market.
Subsequently, the announcement of a snap general election added to the political uncertainty, as did (at the time of writing) the absence of a clear election outcome.
Japan has previously been well-known for its political stability. How should investors react to these unexpected political developments?
History has shown that positioning portfolios around who you think is going to win an election is extremely difficult. We believe it is more important to remain focused on the economic outlook and on stock specific opportunities. In this regard, the fundamentals of Japanese economy are robust and corporate earnings remain strong and have shown continued progress in recent months. We are confident there is enough momentum in the domestic economy to withstand recent political developments.
The Bank of Japan’s (BoJ) unexpected July rate hike contributed to the sharp appreciation in the yen and equity market volatility. How should long-term investors view a stronger yen?
The BoJ’s rate hike reflected confidence in Japan’s macroeconomic development, including wage growth. It also mitigated the risk of further yen weakness, which could have driven higher inflation. Overall, therefore, it should be viewed as a positive for long-term investors.
That said, a stronger yen will exert downward pressure on the earnings of export-related companies. This is one of several reasons why our strategy for the Schroder Japan Trust portfolio favours exposure to domestically-oriented companies.
What are the key aspects of the outlook for Japanese equities that long-term investors should hold in their mind?
There are many reasons to be positive about the outlook for Japanese equities currently and three of them in particular stand out very clearly. These are robust corporate fundamentals, improved governance standards and increasing demand from foreign and domestic investors.
From the perspective of corporate fundamentals, many domestically-oriented companies are demonstrating strong demand and signs of regained pricing power (the ability to raise prices in response to inflation) for the first time in decades. When coupled with improved consumer purchasing power through wage increases, this should drive healthy levels of corporate earnings growth.
Meanwhile, due to the ongoing efforts of the Tokyo Stock Exchange, corporate governance reforms aimed at improving shareholder returns and increasing the valuations of Japanese businesses, have continued. Although these initiatives were initially conceived as part of Abenomics, they are now driven more by regulators and institutional investors than they are by politicians. This should provide them with enough momentum to continue uninterrupted by the current political uncertainty.
Indeed, as evidence of the success of the corporate governance revolution in Japan has accumulated, we have seen growing interest from the global investment community, after years of overseas apathy towards Japanese equities. In addition, there has been an increase in the level of domestic retail participation in the equity market as a result of a new tax-efficient savings scheme, known as NISA.
Importantly, these three factors should not be negatively impacted by Japan’s recent political developments. They look capable of driving continued progress from the Japanese stock market in the years ahead.
Some parts of the market look better positioned to benefit than others, however, so a disciplined, valuation-oriented, active investment approach, such as the one we adopt for Schroder Japan Trust, is well-placed to add further value for investors.
