Does Japan Finally Look Attractive? 

By David Ruff, Partner & Portfolio Manager

The Bank of Japan appointed Kazuo Ueda as its next governor, who was considered a long shot by observers.  The pick induced trader speculation of a fundamental change in the central bank’s direction.  Many believe the BOJ cannot continue its ultra-loose monetary stance of the so-called yield curve control (YCC) policy in the face of rising inflation, recently hitting 4.0%, the highest since 1981 and double the 2% target.  While the timing remains uncertain, YCC will end, at least gradually.  This will ultimately push interest rates and the yen higher.  Unlike the US and Europe, however, where higher rates punished equities in 2022, this may, seemingly paradoxically, provide a tailwind for Japan’s equities. 

As most investors know, Japan equities have performed miserably since 2009, especially when measured in dollar terms with a 5.53% annualized return from year-end 2009 through January 2023.  The US managed 12.57% over the corresponding period.  We’ve highlighted Japan’s many structural problems in previous commentaries including a 2019 commentary titled Japan, so Close to China, and so Far from God.  These include high corporate taxes, mountains of government debt, a creativity-stifling, rote-based education system, and unattractive demographics.  This last issue appears to be beyond the ability of policy makers to fix.  The population is not only aging but also dwindling.  Fewer productive, money-spending people is not good news for the country’s economy.  We’ve noted there can be individual company opportunities, but long-term secular outperformance by the market remains a challenge.  Accordingly, we’ve underweighted the market for more than a decade.

Despite these secular issues, Japan’s equity market fundamentals appear to be the best in years.  Beginning with valuation, Japanese equities trade exceedingly cheap on all metrics.  Notably, the discount measures an incredible 70% on a price-to-book basis compared to the US.  The last time relative valuation reached this extreme, in 2001, Japan returned 12.55% per annum over the next five years, tripling the US return.  True, part of the valuation discount reflects poor profitability with return on capital at 3.2% in Japan versus 7.9% for the US, but it’s important to qualify because Japan’s equity index contains companies that exhibit greater cyclicality.  These corporations suffered disproportionately from Covid. Further, Japan’s return on capital and other profitability ratios had been creeping up on the US from 2010 through 2019.  Now, with the country fully opened from the pandemic and an improved focus on corporate governance, we expect this trend to continue.  This profitability improvement explains why Japan’s corporate earnings growth on a per share basis outstripped the US over the last 10 years (185% to 98%), despite Japan’s slower relative economic growth rate. 

Another key fundamental positive relates to the inexpensive yen, a function of Japan’s anemic economic performance, and the BOJ yield curve control policy which capped interest rates on longer-term bonds.  This held down government interest expense, an important goal, given Japan’s massive government debt load at 264% of GDP.  YCC also helped address Japan’s disinflation battle, a stubborn, lingering problem developed after the bursting of the country’s asset bubble in the 1990s.  Implemented in 2016, YCC kept Japan’s 10-year government bond yields hovering near zero through 2021, which made the yen noncompetitive to other higher-yielding currencies.  The yen fell 49% against the greenback from year-end 2011 through October 2022.  This dive accelerated over the last two years.  Since the end of 2020 the drop measured 30%!  The yen has recovered some since October, but remains the cheapest of the OECD countries, undervalued by approximately 40% to 50% depending on the model used.  In the simple Big Mac model, the sandwich is 45% cheaper in Japan.  The cheap yen enhances Japan’s price competitiveness, boosting exports and enhancing corporate profits.  Indeed, Japan corporations recently registered an impressive 16.9% sales growth.  For comparison, the S&P 500 companies averaged 3.9% sales growth.  This sales growth should remain strong in the interim as Japan equities, through trade, are leveraged to China’s recovery, an economy finally showing renewed signs of life after three years of business-brutal Covid lockdowns.

Although we’ve learned the term “transitory inflationary pressures” turned out to be only partially correct in the US, we believe Japan has less to fear from runaway rising prices.  Although the reported CPI climbed to 4%, core inflation or that which excludes food and energy, climbed by a less-than-scary 1.6%.  Given the country’s extensive trade links, this was mostly driven by the weak yen which should stabilize as the BOJ moves away from YCC.  Additionally, Japan’s economy has successfully lowered its dependency on fossil fuel imports as total energy consumption per capital declined 23% from 2005 through 2020.  Combine this with the fact that the country is not suffering an energy shortage and Japan appears less susceptible to an energy cost shock to the degree experienced by Europe, for instance.    

Finally, in these times of escalating geopolitical turbulence, Japan may be considered a safe haven in the global marketplace.  War continues to plague Europe, and persistent military tensions between the US and China make Japan a comparatively tranquil environment.  The market may be starting to notice.  Over the last six months ending January 2023, Japanese equities advanced 4.86%, an admittedly tame result, but better than the US (‑0.48%).  Emerging markets have enjoyed ramping investment flows lately, but investors should increasingly appreciate Japan’s structural advantages versus the emerging market alternative.  These include an industrious work force, low societal corruption, and strong adherence to contract law. 

In conclusion, despite notable longer-term challenges, the alignment of positive short-term fundamentals makes select Japanese equity investments more compelling now than anytime over the past decade.  Moreover, we believe the BOJ direction change will be the catalyst for a Japan rerating.  In contrast to the quantitative tightening in Europe and the US, where rising interest rates caused a precipitous price-earnings multiple compression, Japan should escape this scenario given already ultra-low valuations and re-energized corporate profit engine facilitated by the cheap yen.  We believe our investments in several internationally geared, Japan-based companies will be very return competitive over the coming market cycle.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.