Improved purchasing managers’ indexes (PMIs), accelerating wage growth and the announcement that the Japanese government will expand fiscal spending for the first time in three years all bode well for the strength of the Japanese economy.
Assisted by higher export volumes, Japan’s economy continued its improvement last year, recording annualised real GDP growth of 1.3 per cent in Q3 2016. This marked the third quarter in a row in which the economy had expanded owing to a boost in export volumes.
However, this was offset by weaker domestic spending, and concerns remain that the benefits of Prime Minister Shinzo Abe’s reform efforts have not yet reached the Japanese consumer.
So is Abenomics doomed to fail? The goalposts always seem to be moving. Nevertheless, there have been concrete changes in Japan, with an improved labour market and better corporate governance. Inflation may actually accelerate this year given the weakness of the yen, a potentially inflationary environment in the US (and elsewhere) along with rising commodity prices.
At the margin this is good news for Japanese stocks. It should be supportive of Japanese revenues, trickling down to Japanese earnings and eventually to Japanese shares.
Two areas that are likely to benefit this year are retail and financials. Japanese retail companies underperformed last year, owing to expectations of a return to deflation and price competition amongst retailers.
Yet with a change in both currency and inflation expectations, those things might be viewed positively for the retail sector. At the same time, with Japanese wage growth accelerating again, I believe there is room for more consumption this year. This should be good news for retailers. Meanwhile, yield curves have steepened globally, including in Japan, which should be positive for Japanese banks and life assurance companies.
In addition, I am bullish on healthcare for structural reasons. Japan is an ageing society, which creates a natural increase in demand for health care. As Japan ages, healthcare companies can accumulate experience in that market, and export it to other markets around the world.
In Japan, as the labour pool shrinks and becomes more expensive, companies are increasingly seeking to outsource non-core operations, such as human resources, to specialist providers. That’s why we believe business-to-business services in areas such as outsourced HR and benefits services still have room to grow.
Thirdly, we are bullish on automation, for example, in robotics. This area will be attractive over the next 10 years because penetration of robotics and other types of automation in China and the rest of Asia is still extremely low compared with more advanced countries, such as Japan, Germany and South Korea.
China needs to climb the value chain, now that it is making more high-end technology products, so it needs to improve quality along its entire supply chain. This is especially the case as wages in China and the rest of Asia are rising, making robots more cost-effective in comparison.
Another tailwind for Japanese equities is a weaker yen, at 115–120 per US dollar. The first thing to say is that yen weakness is not a requirement for Japan equities to outperform, but it is helpful owing to its effect on corporate earnings. Prior to the US election it was about 103 to 104 yen to the dollar, and depending on what actually comes out of the Trump White House it could move in any number of different directions. Still, I remain sceptical that it will weaken to as low as 125.
A final factor to be positive about is fund flows in Japanese equities. The Bank of Japan will be buying 6trn yen of Japanese equities annually, while corporate share buybacks have been robust, hitting 5trn yen in 2016 and can be expected to continue apace this year.
At the same time, domestic pension funds are short of their target allocations for Japan, all of which combined means there is likely to be around 10 to 15trn yen of domestic buying into the asset class this year. If international investors change their attitude toward Japan and decide to raise their weightings, it could really propel the market upwards.
Unlike many other countries right now Japan has the benefit of political stability, with Abe boasting some of the highest approval ratings among leaders in the developed world, which is a final positive tailwind to end on. He is now in his fourth year, and likely to run for re-election as leader for the Liberal Democrat Party again this year, which he is heavily favoured to win. This stability is in stark contrast with other areas in the world, in particular Europe, where many countries are going to the polls this year. And these election results are much less certain. In my view, the market is not appreciating this lack of political risk in Japan.
There are many strong Japanese companies that represent the real growth story in Japan today: companies that can capture domestic demand, tap into Asia’s ongoing evolution and take global market share.
Kenichi Amaki is portfolio manager at Matthews Asia