Looking east from China you see the House of the Rising Sun, otherwise known as Japan. Indeed, you would think Japan would “rise” with its number one export destination, China, being the fastest growing major economy on earth. By supplying critical integrated circuits, machinery, instruments, robotics, vehicles, transportation equipment, LCDs, optical fibers, and specialized chemical and materials, Japan should be leveraged to China’s ongoing development. Indeed, according to the Ministry of Japan’s data, its exports to China have achieved an annualized growth rate of 9.4% over the last two decades ending 2018, only slowing to 6.5% over the last three years. Yet, this has had a marginal impact on Japan’s overall economy which struggles to show sustained, meaningful growth. Why does this matter? Japan ranks as the second heaviest weighted country behind the U.S. in the global equity indices with Japanese firms accounting for approximately 8% of the MSCI All-Country IMI Index, which coincidentally, is close to the country’s GDP weight in the global economy. Yet the U.S., which is responsible for nearly 25% of global GDP has more than 53% of the index. While some believe this suggests Japan represents attractive value, we believe investors should tread carefully.
Recently, Japan and the U.S. inked a new trade deal, but the benefit to Japan will be limited. Notably, despite ongoing strength of the U.S. economy, Japan’s exports to the U.S. have not recovered to 2006/2007 levels and have stagnated since 2015. Moreover, given the global deceleration engendered by the trade war, Japan should not count on an external boost to jumpstart its economy.
Given this environment Japan will likely undertake domestic stimulus to offset the drag. China has introduced several measures including tax cuts to mitigate the trade friction with the U.S. Sadly, the outlook for Japan’s domestic spend is even gloomier than China’s. Backed into a corner under a suffocating government debt load with total debt at well over 200% of GDP, Japan’s policymakers on October 1st raised the value added tax two percentage points to 10%. Historically, these hikes have not been kind to business activity. Recessions followed hikes in both 1997 and 2014, and another year of disappointing growth in 2020 should be expected, despite a temporary boost from next year’s Olympics and another fiscal stimulus program. In Japan, monetary and fiscal stimulus have gradually lost effectiveness relative to structural reforms including deregulation, allowing more immigration, and providing more flexible labor markets. Nonetheless, the country is weighed down by its massively aging population and thus will likely stay in its multi-decade rut. Structural problems include a creativity-stifling, rote-based education system, an aging and shrinking population, a high corporate tax rate, generally poor corporate governance, and a very large number of loss-making/marginally profitable companies. It’s easy to make the case that Japan should be avoided as an investment destination.
Overly relying on macro considerations, however, can lead to missed opportunities, and we believe careful investing in Japan can still be rewarding. There are some positives in Japan that are beneficial including an industrious and loyal work force with very low societal corruption, strong adherence to contract law, and low inflation. These characteristics, combined with specific company attributes, produce some unique investment profiles not available in other parts of the world. In addition, there are a number of areas where Japan still plays a crucial role in the global economy. In technology, Japan’s importance has generally receded over the last decade as earthquakes and tsunamis induced companies to diversify sourcing for wafers and chips to other countries. Still, the industry relies mostly on Japan for key chemicals used in semiconductor and display screen production. This was highlighted recently by the Korean trade spat when Japan moved to restrict export of these important chemicals. Japan also leads in providing precision processing tools used in the back end of the semiconductor manufacturing process known as assembly and packaging. In our ADR portfolios, for instance, one of these toolmakers has provided the sixth best leading return over the trailing three years ending September 2019. Further, Japan’s macroeconomic weakness with its aging society can provide an investment opportunity. With the world’s oldest population, Japan is spearheading innovation in elderly care. Japan leads in technology for tracking dementia-suffering patients, as well as treatments for eyesight deterioration. In our ADR and Global portfolios we’ve invested in a leading Osaka-based ophthalmology company pursuing novel treatments for glaucoma, dry eye, and age-related macular degeneration.
Political roadblocks will slow Japan’s ability to reform and address the structural problems listed above, and, in some areas, we may not ever see meaningful progress. This suggests a market-based investment in the country may not be a winning strategy over the full market cycle. Despite the structural challenges, however, winning investment opportunities can be found in Japan by focusing on company-specific themes. In other words, Japan no longer lives up to the rising-sun moniker implying a bright future, but with perseverance, diligence, and patience you can still find a little slice of heaven investing in Japan.