Is the Japanese market adjusting to the new economic reality, wonders Christopher Querée.

If the WM Charities index is a good guide, then UK foundations continue to have little appetite for Japanese equities. Indeed, the third-largest economy in the world would seem barely to feature in the asset allocation of charities, save for a token holding of two per cent. In the view of some trustees this may be for good reason with memories harking back to lofty valuations in the late eighties, apparently explained away by “different accounting policies” and enough subsequent value destruction to deter a generation of investors.

The advent of ‘Abenomics’ and a powerful rally have shown, however, that the stock market will react swiftly to the prospect of change. With Japanese equities having risen by 62 per cent in the past 12 months, does this reflect a market adjusting to a new economic reality or just another surge in momentum destined for disappointment? Certainly, the Japanese equity market has plenty of form to justify the title of the ‘land of the false dawn’ and, as such, is the recent rally just part of the old and familiar pattern? {{image:{"asset":"7E0529D9-2E72-4DE9-B87FD67AD6AD807F","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

In order truly to believe that it is different this time the key assumption is that the prevailing economic position in Japan will shift from deflation to one of positive pricing or inflation. From this perspective, the outlook appears encouraging. The newly elected Prime Minster, Mr Abe, was swift to initiate a changing of the guard at the Bank of Japan whereby the long-standing and ultra-conservative Governor Shirakawa was succeeded by Mr Kuroda. As a result we now have a governor and policy pledge that not only resembles that of the Federal Reserve in the US but positively out-guns it in terms of aggressive stimulus. Much attention has been given to the $85bn monthly quantitative easing programme enacted by the US and perhaps less to the relative size of the $60bn monthly programme pledged by Japan. Considering that the US economy is approximately three times the size of the Japanese, the Japanese authorities can no longer be accused of half measures in terms of policy action. Equally, as US financial markets oscillate to the will-he, won’t-he debate on the tapering of US stimulus, the Japanese programme is only just gaining momentum and will continue well into 2015.

Much has been made of Premier Abe’s policy pledges under the ‘collective three arrows’ but will they hit the target? To move the analogy from archery to baseball, the first policy, namely qualitative and quantitative easing, has hit a home run. The announcement in April that the size of the Bank of Japan’s bond purchases and the monetary base would be doubled prompted both a significant depreciation in the yen, (some -10 per cent in two months against the US dollar), a corresponding increase in Japanese export performance and a rise in domestic consumption. The second package, centred around fiscal stimulus, will see over 10tn Yen directed to reconstruction, disaster prevention and corporate investment incentives. The third prong, structural reform, aims to increase capital spending within three years, reform the labour market, particularly in respect to women, and end protectionism, especially in the agricultural sector.

A new and more aggressive approach to monetary policy has so far succeeded in capping both real and nominal bond yields.

This compares to previous cycles where a rising stock market was accompanied by a weak bond market environment that ultimately snuffed out the equity market rally and provoked its reversal. {{image:{"asset":"4E9F4B93-4C13-49CC-95846BA88F89E255","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

Valuations are also starting from a different point. It is notable that prior to the recent Abe rally, the Japanese market was struggling for a rating over book value. This compares to previous cycles where valuations were extended from 1.5 times to 2.5 times book. In this context, the market remains attractively priced relative to its international peers and offers the potential for further re-rating.

After a slow response to the financial crisis of the late 1980s and years of subsequent stagnation, the Japanese financial sector also appears supportive to further performance from the domestic stock market. Lending policies at Japanese banks have generally been cautious, resulting in low loan-deposit ratios and modest nonperforming loan issues. The strength of the financial sector should, therefore, provide a solid platform for the further expansion of the Japanese economy. Unlike previous cycles, where the banking sector has been at the centre of a correction in the stock market cycle, the banks are now in a different place and appear supportive of further expansion in the Japanese economy.

Another notable feature of corporate Japan is the extent of operational gearing, or the sensitivity of profitability to rising sales. As a result of years of economic stagnation and deflation, Japanese companies have, in the absence of top-line growth and in face of the reality of top-line contraction, been forced to run tight ships and keep costs under control. Even so, they have found it difficult to raise operating margins given this backdrop. As a result, it is estimated that a 1 per cent increase in sales in Japan equates to a median increase of 4 per cent in earnings. To put this in context, the equivalent sensitivity of earnings to sales is nearer 1 per cent in the US and Europe. With the prospect of some modest pricing power, this presents an enticing trajectory for Japanese corporate earnings. At a time when corporations in the West are achieving multi-year high margins, and the clamour is growing for labour to share in the recovery, Japan would appear to offer much greater scope for positive earnings surprises. {{image:{"asset":"8C42768D-6404-4ED4-91626E36EE077FA1","alt_text":"","dimensions":"","quality":"mediumPerformance","alignment":"auto","spacing":"5","copyright":"","caption":"","link":"","link_asset":"","link_page":"","link_target":"_self"}:image}}

Clearly with Japan still at the start of a mammoth stimulus programme it is appropriate to consider the currency risks posed when investing in Japan. It is quite probable that having been something of a bolthole currency during much of the recent global financial crisis, the yen will now endure a period of weakness. Indeed, the key to making decent returns in the recent Abe rally has been to hedge yen exposure back to sterling, for UK-based foundations. Our approach has been one of direct investment in equity holdings predominantly in the large-cap area, leaving us free to hedge back the subsequent yen exposure.

Given the extent of the policy measures enacted by Japan, there are of course inherent risks of a response from the likes of China or Korea, in order to regain some competitive currency advantage. While the G7 may currently be tolerant of Japanese policy, the currency war issue does have the potential to resurface on the international agenda. Meanwhile, it is clear that, geopolitically, the US is supportive of a resurgent Japan in juxtaposition to the growing economic power of China. The recent political spat over the Senkaku Islands is illustrative of the potential tensions in the area, although it also demonstrates that the mutually beneficial trade links between the two nations are likely to prevail over political rhetoric.

As investors increasingly move away from the constraints of traditional benchmarks it is likely that endowments will follow the trend of global institutional investors and begin to address the underrepresentation of Japanese equities in portfolios. The political and economic outlook has yet to be fully reflected in valuations. Equally, at a time when there is an increasing focus upon the individual sovereign risk issues within the emerging market block, and earnings assumptions in the BRICs are being re-examined, meaningful exposure to Japanese equities is likely to become increasingly less contrarian.

Christopher Querée, investment director, Ruffer.