• William Bourne

The conundrum of Japan updated | Linchpin

Linchpin looks again at the conundrum of Japan after a visit to the country. Valuations are cheap and provide downside protection, but significant headwinds remain to limit the upside. Active stockpicking may do best.

I wrote an article on the Conundrum of Japan a couple of months ago. I appreciate that investors and asset allocators are considering weightier matters right now, but I made the point then that Japan remains astonishingly cheap both in relative valuation and absolute currency terms.

I have just come back from two and a half weeks in Japan where I met a range of investors and managers as well as travelling around the country, and since taken part in a round table organised by Camradata. This article updates my previous one The conundrum of Japan today | Linchpin.

Japan's domestic economy seems prosperous

Obtaining a visa to visit, required as a result of COVID, was not easy. The restrictions have since been lifted, but it was no surprise to me that we saw almost no foreign tourists even in Tokyo. Despite the delayed Olympics last year, the number of overseas visitors to Japan in 2021 was less than 0.25m, a 99% fall since 2019*. 2022 has seen a small recovery to 0.8m in the first eight months of the year but given the build-up of Japan’s tourist infrastructure for the Rugby 2019 and the 2020 Olympics, it represents a vastly underused resource.

Hotel and restaurant proprietors grumbled about the lack of custom, but residents have partially filled the gap. We did not go to major tourist attractions such as Kyoto, but the volcanic ‘hells’ at Beppu and the shopping street at Yufuin were doing good custom. We even had to queue to get into one restaurant in rural Niigata-ken. I also noticed the number of new cars on the streets. Perhaps this is the result of the Government’s COVID hand-out to residents or money which would have been spent on foreign holidays, but the parts of Japan we saw looked prosperous.

Headline inflation has risen above the Bank of Japan’s 2% target, but is still very low compared to elsewhere. Anecdotally a number of people told me that, as in the West, it seemed higher than that on the street. I also saw the first labour protest (in Kita Kyushu) for higher wages that I have seen since the 1980s. If I had to name one future ‘surprise’ in Japan, it would be much higher than expected inflation.

Will the yen pivot?

The yen is undoubtedly cheap, with a Big Mac costing only just over half what it does in the United States, but the Bank of Japan appears committed for the time being to very low interest rates. The latest data from our friends at CrossBorder Capital suggests that despite this they are in fact tightening quite sharply by reducing the size of their balance sheet. Their monetary base is contracting faster than any other central bank. In time this must lead to a higher yen, but there remains a considerable question over when.

The BoJ will have at some time to pivot away from its current yield curve target of zero yield at the ten year bond tenor. When yield curve control finishes, bond yields will surely rise right along the curve. That may, as in the U.K., have unintended and undesired second order consequences where institutions have leveraged their fixed income portfolios to increase the return. So, it is not a given that the yen will rise when the brakes of monetary tightening are applied.

Labour shortages have had little impact

The labour shortage was notable, but as ever Japan Inc is resourceful in solving the problem. Robots collect dirty dishes, machines have largely replaced the super-efficient staff who used to man midoriguchi (ticket offices) at stations, and smaller and more rural trains have become one man-operated. However, as is the Japanese custom, at Haneda Airport and Tokyo stations there were always staff on hand to help. Historically roles like these, which would be considered superfluous in the West, have been a way of ensuring full employment, and that does not seem to have changed.

One area where there has been little progress so far is the employment of women in professional roles. I visited a number of major asset managers. One in particular whom I challenged five years ago on this subject still had almost no women in its portfolio management or research team. They recognised the problem, but to date had not been able to overcome the cultural problems – both internal and external.

Japanese equities are cheap, but there are reasons

Turning to markets, Japanese equities are undoubtedly cheap on many metrics. The weakness of the yen is another reason for suggesting there is a good entry point for overseas investors. However, the market has not risen in response to the currency’s fall, and many overseas investors see the market in aggregate as a value trap. While Price to Book is 25% of the United States’ equity market, Japanese tangible assets earn far less return than U.S. assets, which are often leveraged and further geared by the existence of intangible assets alongside.

The counterarguments to that are that Japanese equities have greater scope to expand earnings through leverage etc, and there is also more downside protection, because a stock trading at a P/B below 1x is not going to fall as much as one on 10x. Investors are also being paid a substantial yield while waiting.

Traditionally a stronger yen has not been good for Japanese equities because exporters have found it harder to compete with a strong currency. However, this year there has been little benefit from the weaker currency, and I suspect that dynamic is changing. Japan’s exports tend to be high value-added and are becoming less sensitive to currencies; on the other hand, tourism levels may be more closely related. We had a blissful time with the yen at thirty year- lows, while tourists to the U.S. this year have all said how painful it was financially.

Supply and demand poses a headwind for Japanese equities

Japanese equities have not fallen as much as other ‘risk’ assets, particularly so from a common currency perspective if investors hedged their yen exposure. Portfolios, therefore, tend to be overweight Japanese equities. Our friends at CrossBorder Capital suggest that Japanese equity holdings in aggregate are around 30% higher than the five-year average.

A further problem is the overhang of stock held by the Bank of Japan after the purchases of equity ETFs over the past ten years as part of its QE strategy. As a result, it now holds about 7% (Bloomberg data) of the overall stockmarket, and it is not clear how or when this position will be unwound.

Stock-picking skills will be needed to generate returns

So, what does the future hold for Japan? Economic growth will continue low, but other countries may be joining Japan here. One interesting statistic is that the Japanese fertility rate seems to have bottomed out since about 2005. It has not meaningfully recovered but is higher than (e.g.) Korea or China, and immigration is gradually filling the gap. Inflation will rise in due course, and Japan will move away from zero rates. The currency should recover on the back of that once speculative short.

It is also clear from a macro-economic perspective that Japan and Korea are at some point going to have to choose whether they will centre their relationships around China or the U.S. They may be able to straddle both blocs for some time to come, but the day when China enters Taiwan or is more aggressive around the Sentaku Islands dispute, that will no longer be possible.

At an aggregate level, there are still significant headwinds for the equity market, countered by the fact that the downside is limited. In a more difficult market environment, that plus the yield on equities may be enough for investors, but I suspect successful investment will depend on stockpicking skills more than the asset allocation decision.

*Source: JTB Tourism Research