Since May of this year we have been overweight to Japanese equities, encouraged to increase our exposure by improving corporate governance dynamics that have supported a step change in share buybacks and dividend payments.
This turn of events is the legacy of the late Shinzo Abe, Japan’s Prime Minister from 2006 to 2007 and again from 2012 to 2020. Reforms that he instigated, which came to be widely known as ‘Abenomics’, sought to improve Japanese corporate profitability and capital efficiency. Now, a year on from his assassination, signs of fruition are emerging with capital efficiency improvements increasing the returns generated on investors’ equity.
In perhaps a fitting legacy, reforms continue. In April of this year, another policy move aimed at increasing Japanese corporate profitability was launched; Action Plan for Substantiation of Corporate Governance Reform1. Key within this is the Tokyo Stock Exchange’s requirement for firms to disclose risk-taking plans and measures taken to achieve growth while keeping profitability in mind. In particular, firms with a price-to-book (P/B) ratio below 1x will be flagged and requested to “properly identify” their cost and efficiency of capital.
Japanese P/B per RoE premium to global peers
Source: Bloomberg, 9 August 2023
As at the end of July, Japanese equities had rallied almost 16% since this announcement, outpacing global equities in local terms by 5%2. Naturally, questions have emerged around whether the potential upside is now factored into prices. We note that the premium in terms of P/B per unit of return on equity (RoE) of Japanese stocks versus non-US global peers has increased. However, it has only moved to the extent that a 0.5% increase in RoE would shift this back to median levels. Our Global equity team have flagged that the magnitude of cash on some Japanese firms’ balance sheets provides clear opportunities to increase RoE by around 5%. As such, we do not view the prevailing Japanese rally as overextended.
Aside from the long-term reform-driven upside for Japanese equities, we also see medium-term tailwinds from both the domestic and external environment. On the domestic front, lingering Covid-19 restrictions into 2022 set a low starting point for activity, relative to other regions. Today, consumer confidence has recovered, household balance sheets are healthy and domestic consumption still has room to improve before it reaches pre-Covid levels. The scope for Japan’s tourism industry to continue improving, relative to 2019 levels, is also notable.
From an external perspective, the case can be made for an upcoming period characterised by a change to the typical inverse Japanese yen and Japanese earnings relationship. Increased non-Bank of Japan key developed market central bank rates have reduced global-growth expectations and associated cyclical Japanese earnings expectations, while depreciating the yen through increased rate differentials. From here, with rate differentials expected to gradually reduce from both sides, alongside a potential bottoming of the global cycle, the case can be made for an appreciation in the yen alongside an increase in Japanese earnings. This provides an attractive set-up for non-yen-based investors such as us.
In a globalised world where tying regional equity market performance to regional economic outcomes can be difficult, a unique set of catalysts should specifically benefit Japan-listed companies.