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Japan Smiles On Japanese Economy, Trade Risks May Drag Performance

Tom Burroughes, Group Editor , 24 January 2019

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Japanese companies continue to respond positively to the improving domestic conditions as they begin to regain some pricing power after almost two decades of deflation, the firm argues.

Japanese markets have not gained as much as they could have done on the greater global recognition of the country’s supply-side reforms, with trade tensions between the US and China likely to be a background worry later this year, Schroders argues. Even so, domestic conditions in Japan continue to improve, it said in a note. 

“While investors seem destined to live with higher levels of external risks, especially on trade, some of the domestic risks have receded in recent quarters and we should therefore have more conviction in our view of current Japanese equity market valuations,” Ken Maeda, head of Japanese equities, said in a note. 

Equity markets in Japan fell by 12.88 per cent in 2018 from a year before (source: MSCI), in a year that saw almost all stock markets fall into the red. Based on the MSCI Japan Index level, Japanese equities have a forward price/earnings ratio of 11.28 times earnings, cheaper than the 16.09 p/e ratio for the MSCI World Index of developed countries’ shares.

After languishing for decades, the Japanese economy has been rejuvenated by the current government’s reflationary policies of aggressive fiscal and monetary loosening, coupled with reforms to how companies are run – making it easier for shareholders to hire and fire bosses and restructure.

The changes mean that Japan, out of favour with investors since the property market and stock market crashed in the late 80s, is stirring attention again. 

The UK-listed investment firm and private bank argued that Japan has so far managed to avoid a trade fight with the US. Maeda noted that Japan has also "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." Japan should be prepared for secondary effects from the US-China trade tariff measures that have rattled investors recently, the firm said. 

Schroders’ Maeda expects domestic financial and economic policy will remain steady this year.

In early October last year the government said that the next increase in consumption tax will go ahead, as planned, in October this year. Besides some exemptions from the new higher rate, the government is also planning a series of stimulus measures designed to mitigate the extent of economic dislocation caused by previous tax increases. 

“At this stage, it is unclear what the net impact to the economy of all these measures might be,” Maeda said.

“Meanwhile, although we expect no substantive change to monetary policy in the near future, there is a chance that the Bank of Japan may choose to act earlier than strictly necessary in order to avoid making any change around the same time as the tax increase,” he continued.

Exit plans
Beyond October this year, Maeda said long-term equity investors should be ready for the country to quit existing monetary policies within their time-horizon.

“If the authorities are able to declare a sustainable exit from deflation, this could dovetail well with the final stages of Prime Minister [Shinzo] Abe’s tenure. Although these appear to be largely political considerations, they reflect the underlying improvements in the real economy which are, in turn, driving the corporate profit growth we are expecting over the next couple of years,” he said.

The Japanese labour market is strengthening, putting upward pressure on wages, Maeda continued.

“The extent to which higher participation rates have offset Japan’s known demographic issues continues to be widely under-reported, but should properly be regarded as a key success for government policy.

Although this particular trend must reach a natural peak soon, the tightness of the labour market is capable of sustaining the recent upward pressure on wages. This will ultimately feed through to inflationary expectations which will, in turn, generate better pricing power for domestic-oriented companies,” he said. 

“Capital expenditure is also running well ahead of companies’ earlier expectations. This is partly a rational response to the macro impact of labour shortages but is also a reversal of the long-term trend of underinvestment, especially in technology and systems, through the period of deflation,” he said. 

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