Rathbones’ Chillingworth: Why we’re still positive on Japan

Chillingworth Julian RathbonesSince 1965, the volatility of Japan’s major stockmarket indices has consistently exceeded that of the US. This reflects persistently low Japanese interest rates, where the asset values swing widely with small rate changes and a low proportion of returns come from dividends. But the situation is changing, opening up the exciting prospect of attractive valuations relative to other developed markets, rising profitability, rising returns to shareholders and falling volatility.

In the year that Prime Minister Shinzo Abe’s plan should have taken a firm grip, Japan’s economic performance has been underwhelming. Further, investors have (to some degree, quite rightly) become concerned that the bull case for Japanese equities is predicated on just two threads: improving corporate governance and the asset allocation shift in favour of equities by the massive Government Pension Investment Fund. But while change is notoriously slow, we don’t believe that now is the time to throw in the towel on Japan.

First, Abe’s government recently announced plans to lower the effective corporate tax rate by 3.3 per cent over two years, starting in April 2016. This pledge brings Japan more in step with international levels and encourages firms to invest and pay higher wages. Second, earnings revisions remain the highest among the major developed regions and the market is cheaper than the US and UK. Notably, Japan is one of the few countries where the earnings yield is at an historical extreme versus real government bond yields.

The GPIF’s shift towards equities is just the tip of the iceberg, we believe, as other institutional investors and retail investors follow. There are some valid concerns about the impact of Asia’s slowdown on Japan — 18 per cent of exports went to China in 2014, making it Japan’s second-largest export market after the US. But net exports represent a lower share of GDP than in many other developed countries including Spain, UK, France and Germany.

Japanese monetary policy also remains highly supportive. It has led to negative real interest rates, which have sparked reflation. And in a tight labour market, wages have been increasing. Meanwhile, commercial rents are increasing as office vacancies fall and house prices are rising, leading to a greater recovery in inflation expectations.

Significantly, there has also been an encouraging shift in corporate behaviour. Share buybacks hit a record high in May, while dividend payouts increased markedly this year too. Whereas in previous periods of yen weakness, Japanese companies cut prices — good for sales, bad for profits — that is no longer happening.

The change in management culture, now keen to promote better corporate responsibility, is reflected in the enthusiasm to squeeze into the Nikkei 400, representing those companies that meet such criteria as higher returns on equity. Furthermore, the new corporate governance code became effective in June, with companies now required to comply or explain why not. When combined with incipient inflation, such pressures should see Japanese companies increasing their dividends significantly.

Some estimates put the amount of cash that could be deployed by Japanese companies as high as 34 per cent of their market cap, compared with a dividend yield under 2 per cent. Such cash will also be used for share buybacks – few analysts are modelling a further sustained reduction in shares in issue in Japan when looking at future returns on equity. We believe these could rise to 12 per cent if cash holdings return to their pre-2008 levels.

Time for the land of the rising sun to outshine?

Julian Chillingworth is CIO at Rathbones.