Sentiment towards Japanese equities has often been challenged by investors with memories of being burned in previous cycles.
However, Japanese companies might be among the best-placed to withstand a potential downturn in global markets next year, according to several fund managers.
While 2018 has proved a disappointing year for Japanese equities – the TSE TOPIX index fell by 8 per cent (to 20 December) in sterling terms, compared with a 3.4 per cent loss for MSCI World index – there could be some cause for optimism in 2019.
Performance of indices YTD
Source: FE Analytics
“Although global political and macro headlines weighed on its stock markets in 2018, Japan’s economic and market fundamentals remain on the right track toward normalisation,” said Daiji Ozawa, chief investment officer for Asia Pacific-Japan equities at Invesco Perpetual.
Indeed, Capital Economics’ chief Asia economist Mark Williams and senior Japan economist Marcel Thieliant said while concerns over the global economy have been surfacing recently, the risks to the Japanese outlook have diminished.
“The global slowdown we anticipate will be a headwind in 2019,” they explained. “But there is growing evidence that Japan’s economic contraction in Q3 was a one-off. The labour market remains tight, consumer spending is recovering and output from industry is too.”
More importantly, said the pair, the Japanese government is preparing “countermeasures” to offset a hike in the consumption tax next year.
“The last time the consumption tax was hiked, from 5 per cent to 8 per cent in 2014, the economy was tipped into recession and household spending stagnated for the two years that followed,” they noted.
However, next year’s tax rise – from 8 per cent to 10 per cent – will be smaller and as a result will have less of an impact.
While the economy should be well-positioned in the event of a global downturn, corporate Japan is also in much better shape than some of its international peers.
Dan Carter, manager of Jupiter Japan Income fund, said many Japanese companies hold less debt on their balance sheets than they did when they entered the global financial crisis, with more than half of firms outside the financial sector in a net cash position.
Additionally, the proportion of Japanese book value which is tangible assets is “considerably higher than other global markets, notably the US”, he said.
“By rights this greater financial stability should be to Japan’s benefit in the next downturn,” Carter explained.
Source: BofA Merrill Lynch Global Fund Manager Survey
Another positive for Japanese corporates is that they are much more profitable than a decade ago.
“Japanese companies walked into the last crisis with an aggregate pre-tax profit margin in line with previous peaks, of around 4 per cent,” said Carter. “Today that number is above 6 per cent and, we believe, the result of structural improvements in the corporate sector rather than merely due to the strength and length of the cycle.
He added: “We would argue that these structural improvements should stand Japanese companies in good stead when the cycle turns, and that the next trough in profits is unlikely to be as deep as the last.”
As US president Donald Trump’s administration continues to stoke tensions over trade with China, Japan has developed an improving trade relationship with its regional rival.
“Sino-Japanese trade has been on the rise and the rhetoric between the two nations has been increasingly friendly and trade-focused,” he said. “It is not unreasonable to expect that a continued normalisation of relations, and associated uptick in trade between Japan and China, could help soften the impact of the next global slowdown.”
However, it remains to be seen how long Japan can avoid confrontation with the US over trade, with Schroders head of Japanese equities Ken Maeda saying despite greater domestic stability, the country may find itself drawn into full-blown trade war.
“Japan has avoided a focus on its own trade surplus with the US but the persistent imbalance in autos, in particular, remains a potential easy target for the Trump administration,” he said. “The secondary effects of the US dispute with China could also become more significant for Japan over the next 12 months.”
The economy also faces long-term structural issues, as Invesco Perpetual chief economist John Greenwood noted.
“The Japanese economy continues to experience sub-par growth and sub-target inflation,” he said. “Despite five years of aggressive quantitative and qualitative easing by the Bank of Japan, little progress has been made in restoring growth and particularly inflation to normality.
“The economy continues to grow at a modest pace of 1-1.5 per cent, due largely to the ageing of the population which has meant that the workforce has been declining.”
Greenwood added: “Also, quantitative and qualitative easing has made very little impact on the growth of banks’ balance sheets and hence on money or credit growth, with the result that inflation has remained well below the Bank of Japan’s 2 per cent target. I expect little change in 2019.”
As such, it may take some time for international investors to come back around to the Japanese market.
“Overseas investors have continued to take a relatively fickle approach to Japanese equities,” said Schroders’ Maeda. “In aggregate foreigners tend to be influenced by market momentum, appearing as sellers into market weakness and buyers into strength.
“The result is that we have seen no follow-through from the improved visibility on corporate profits and the recent market setback has led to further de-rating of market valuations.”
Additionally, as the Bank of Japan a large consistent buyer of equities via exchange-traded funds (ETFs) there is a risk of distorting markets prices, said Maeda, although it should not cause problems any time soon.
“For 2019, however, there is no reason to expect the scale of buying to fade and it is definitely much too early to worry about the potential impact of the central banks holdings being unwound,” he added.