by Akira Fuse, Equity Institutional Portfolio Manager, Carl Ang, Fixed Income Research Analyst, Ross Cartwright, Lead Strategist Investment Solutions Group, MFS Investment Management
In this paper, we share our perspectives on the positive developments we have observed in Japan and why these remain supportive for equity investors.
Japanese equities have woken from a deep slumber, but is the rally sustainable?
There are several reasons why investors are increasingly focusing on Japanese equities and opportunities in the world’s third largest economy. Among them, loose monetary and fiscal policy are supportive for growth in the real economy and lower interest rates and broader risk premia for the financial economy. In this paper we share our perspectives on the positive developments we observed in Japan and why these remain supportive for equity investors.
Yield curve control, quantitative easing, fiscal stimulus
When viewed through a balance sheet valuation metric, Japan is cheap (i.e., low book values), but inexpensive valuations in of themselves do not guarantee returns. However, continued improvements in corporate governance and the positive feedback loop from investors is finding its way into valuations.
In our view, the improved backdrop is largely a result of the three arrows of Abenomics: monetary easing, fiscal stimulus and structural reforms. We observe signs that all three arrows are heading in the same growth-positive direction and will continue to provide support for Japanese equities.
While Abenomics is broadly supportive of growth, the consequences are not uniform. For example, the loose monetary stance maintains downward pressure on the yen, which has advantages for exporters while disadvantaging importers. The pace of reform arising from corporate governance measures can also depend on idiosyncratic factors like management succession. This makes it increasingly important to be selective in Japanese equities.
First arrow, monetary easing: The yield curve control debate has been about finetuning a broader framework of continued monetary easing.
Much of the current fixed income market focus has been on the Bank of Japan (BOJ) and its yield curve control (YCC) policy of the 10-year Japan Government Bond (JGB), where there is a 0% yield target. Following pressure in the currency and bond markets arising from this effective peg, the yield band was widened from ±0.25% to ±0.50% in late 2022 under prior BOJ governor, Haruhiko Kuroda.
More recently, under the leadership of new BOJ Governor Kazuo Ueda, there was further widening of the trading band to ±1% on the expectation that a proactive technical adjustment will enhance the sustainability of the overall YCC policy (Exhibit 1).
Stepping back and taking a big picture view, these measures should be considered more as finetuning a continued monetary easing stance than a straightforward tightening of monetary policy that stands in sharp contrast with other advanced economies.
- Interest rate policy – The BOJ remains the only major central bank to maintain a negative interest rate policy (NIRP) of -0.1% despite various underlying measures of inflation already materially exceeding the 2% target, resulting in a significant decline in real interest rates. By contrast, many other developed economies’ policy rates exceed 5% (e.g., United Kingdom). This widening interest rate differential has encouraged currency carry trade activity that has depressed the yen substantially.While a narrowing of the interest rate gap may support the yen, we expect any improvements to be very modest and for the yen to remain a favored funding currency for the carry trade. Importantly, the structural depreciation drivers for the yen remain intact such as trade deficit persistence.
- Balance sheet policy – It is worth emphasizing that the BOJ is still undertaking purchases of Japanese Government Bonds alongside corporate bonds and commercial paper. In other words, quantitative easing (QE) continues which raises the money supply, keeps the yen weak, yields low and means an even larger balance sheet for the BOJ. The BOJ now owns more than half of the stock of outstanding JGBs on top of its holdings of equity exchange-traded funds and real estate investment trusts.By contrast, not all advanced-economy central banks conducted pandemic-related QE (e.g., Bank of Korea). But for those that did, passive quantitative tightening (QT) is now the default stance for many, such as the Reserve Bank of Australia, which has allowed its existing bond holdings to mature without re-investment. The risk is that these central banks pivot to active QT, where the bonds are sold before maturity, like in Sweden, which is expected to support their currency.
NIRP and YCC in the financial economy anchor interest rates at low levels for the real economy and market expectations of a policy rate increase remain modest. Moreover, our BOJ policy baseline assumes little prospect of a NIRP and YCC exit in the current fiscal year whilst Governor Ueda oversees a long-term review of monetary policy amidst increasing uncertainty around the regional and global economy.
Second arrow, fiscal stimulus: Japan’s sovereign indebtedness is recognized as high but sustainable.
It is worth reflecting on the high and rising levels of Japan’s sovereign indebtedness, that has been sustained over the decades, likely reinforcing the policy impression for some that there is still significant headroom for debt-financed fiscal stimulus. There is little pressure on the government to undertake fiscal restraint against a background of low interest rates when there is sufficient demand for deficit-financing bond issuance, like from the QE policy which makes the BOJ a ready buyer of government bonds. All of which is supportive of growth.
However, the concern is that the existing stock of debt is high. Could the high debt levels become a material spending restraint because of market concerns over fiscal sustainability? We assess this as unlikely given Naoyuki Yoshino and Hiroaki Miyamoto’s analysis for the Ministry of Finance government think tank.1 Applying their work to more recent data finds that because of Japan’s unique market and economic structure (i.e., low-growth, highsavings, super-ageing economy), the continued trend higher in Japan’s government debt ratios is sustainable, both in theory and practice.
Third arrow, structural reforms: Corporate governance reforms creating the biggest buzz.
The Tokyo Stock Exchange (TSE) is actively implementing the third arrow of Abenomics through measures to unlock shareholder value. These policies include board structure and holding boards accountable, compelling companies to understand their cost of capital and forcing companies whose stock price is below book value to disclose policies for improvement. They are also driving more constructive dialogues with investors and improving investor disclosures in English.
Over the past two years, there have been significant changes in following areas:
- Board restructures
- Increasing shareholder payout ratios
- Improving engagement with corporate management
Board restructuring has significantly increased.
For example, over 90% of TSE listed companies have implemented the recommendations of the Corporate Governance Code that independent members should constitute at least one-third of the Board. Non-compliance will lead to a “please explain” from the TSE. In addition, the proportion of female directors is increasing (Exhibit 2). However, there remains substantial room for improvement. Prime Minister Fumio Kishida has announced a draft policy to encourage participation by women in the labor force and improve gender equality. Unusually for Japan, it contained some specific targets, for example, that by 2030, 30% of TSE Prime company executives should be female.
Shareholder payouts have been creeping up due to demand by investors and a relatively strong earnings environment (Exhibit 3). Despite COVID-related disruptions, payout trends have been recovering rapidly, hitting a historical high in 2022 as Japanese equities are growing their dividends considerably faster than US companies.
In addition, quarterly share buyback announcements reached new heights in May 2023. These accelerated corporate actions were likely triggered by TSE’s efforts to improve returns and lift ROE as TSE Prime listed companies are now required to disclose their improvement plans for low Price to Book and ROE. Historically, lower returns are partly a result of Japanese companies being overly conservative in managing their balance sheets (Exhibit 4). This is evidenced by roughly half of major index constituents holding cash in excess of their total debt obligations. The recent boom in buyback activity is attributed to companies putting some of this cash to work in trying to improve ROE by reducing the denominator.
One of the biggest qualitative changes we have observed is management’s acceptance of engagement meetings. Investor pressure has been steadily increasing, but corporates are also looking to engage with long-term shareholders who provide stability to their share register. This greater willingness to engage and restructure has seen a continued increase in activist interest, reaching all-time highs in 2022.
The sleeping giant is awakening. Growth supporting fiscal stimulus and monetary easing looks set to continue. Structural reform is starting to gain momentum and corporate governance improvements and willingness to change are real and lasting.
The path may be volatile but, in our view, Japanese equities look set to continue benefiting from pro-growth macro policies and corporate Japan’s increasing focus on shareholder return. However, given the differing rates at which management teams are adopting reforms, and macro policies that favor certain sectors of the economy (e.g., exporters), we believe it is important to be selective in approach when picking Japanese stocks.
1 Reconsideration of the “Domar condition” to check sustainability of budget deficit. Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.17, No.3, November 2021.
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