by Daisuke Nomoto, Senior Portfolio Manager
Japan should experience a decent economic recovery after the Great East Japan earthquake in March 2011. The Japanese economy is expected to grow by 2+ percentage points in 2012 driven by reconstruction spending and stronger private consumption. This is a stark contrast to euro-zone countries’ recessionary or near 0%growth outlook. Japan’s corporate earnings are expected to grow by about 20% in 2012, which is much faster than Europe’s low single digit earnings growth and even higher than the United States’ high single digit growth expectation. So from a short-term perspective, Japan is relatively attractive given its temporarily inflated growth outlook. Unfortunately, this is not the case from a long-term perspective.
Since the Japanese government has been able to rely on domestic savings to finance the fiscal deficit, Japan is not facing the same kinds of constraints as some of the eurozone peripheral countries. However, as the current account balance deteriorates, Japan’s internal financing structure will become threatened and it may become “Americanized” i.e. dependent on external financing with a current account deficit. If Japan’s current balance turns to a deficit, capital inflows from abroad will become necessary to finance the fiscal deficit. Although Japan maintains a surplus in its income balance due to a significant amount of interest and dividend receipts from overseas, it is reasonable to assume that a deficit could occur in the current account balance in a decade or so. While the amount of Japanese government securities and local government securities held by foreign investors was just 6% of gross domestic product (GDP) at the end of last year, foreign investors actually purchased about 30% of the incremental portion of issuance in FY2010.
The Reinhardt and Rogoff book titled “This Time is Different” concluded that higher levels of government debt had a direct impact on subsequent economic growth. Quantitative research at Sanford Bernstein also suggested that Debt-to-GDP above 90% depressed future economic growth by 1%-2% in developed economies and 2%-3% in emerging markets due to a combination of higher interest expenses and attempts to bring down the level of indebtedness (cf. Japan’s federal government debt-to-GDP is 208%, U.S. 68%, Italy 110%, etc.).*
Japan’s net public debt has increased ten-fold in the past 20 years fuelled by a rapid rise in social security spending. Consequently, increased taxes and social security reforms are critical to sustaining investor confidence. A bill to increase Japan’s consumption tax rate to 8% from 5% from April 2014 and to 10% from October 2015, recently passed the lower House. We think this is an important first step to tackle the nation’s leverage issue. It is also important to draw the potential of the private sector and create an environment to improve productivity by utilizing various technologies and intellectual capital. We think that reforms should focus not only on the national debt problem but also address the constraints to growth including the aging population, ineffective industry regulations, low female labor force participation, etc. If the government authorities come up with persuasive measures to address some of these issues, then the equity market would react positively, especially given the very low expectations. That being said, Japan’s long-term challenges are not an easy fix.
So we look at Japan as a place to find globally competitive but inexpensive stocks, rather than a destination to aggressively shift assets to based on a macro evaluation.
*Note: If you look at a country’s “total debt”, which includes government debt as well as the debt of financial institutions, non-financial businesses and households, the 10 developed economies’ (Canada, France, Germany, Italy, Japan, Spain, South Korea, Switzerland, U.K. and U.S.) total debt increased from 200% of GDP in 1995 to more than 300% of GDP by 2008. Despite this mounting debt in the developed countries, it is interesting to note that total global Debt-to-GDP has barely changed during the past decade, as declines in the emerging markets offset the rise in developed economies, which means that much of the developed market borrowing is being financed by emerging market savings.
