Japan could be vulnerable to further macro disappointments

By Michael Stanes, Investment Director at Heartwood Investment Management

Despite surging ahead in the first half of 2015, the Japanese equity market has reversed much of the year-to-date gains since July. The pullback coincided with a strengthening yen during the period of risk aversion sparked by worries over China's economic slowdown.

The market has been interpreting recent economic disappointments, including persistently weak inflation, as a sign that the Bank of Japan will provide further policy support, potentially by the end of this month. Japan's macro picture has been uninspiring. Export levels have deteriorated since March, a large factor being the slowdown in demand from China. But it is not just external demand that has hurt. Private consumption fell 2.7% in the second quarter and that has been in spite of firm labour market conditions.

Bank of Japan Governor Kuroda has spoken in relatively upbeat terms on the economic and inflation outlook, including his reiteration last week that disinflationary energy trends are likely to be transitory. There are a few signs that the second quarter slowdown is starting to turn around, with the latest household survey report showing consumer spending picking up over the summer, while wage growth is also making modest improvements.

Bank of Japan Tokyo (PD)

Therefore, we believe there is risk that the market's hopes of further stimulus at month-end could be disappointed. But in any event, policy support alone is not the ultimate driver of long-term returns. Rather, it is the micro story that continues to be of interest to investors, albeit with the backdrop of policy support. And that is why we have recently taken the opportunity to add to our overweight Japanese equity position, which was established late last year, on this weakness.

Developments in corporate Japan are heralding change. As has been widely discussed, a new corporate governance code went into effect in June, which followed the launch in January of a new index – the JPX Nikkei 400 – to focus on return on capital. In addition, shareholder activism has been gaining momentum: for example, shareholders are being encouraged to use voting rights to target an average return on equity of 5% over five successive years.

The overwhelming aim of such initiatives is to unlock shareholder value. Years of deleveraging and balance sheet repair have placed corporate Japan in relatively rude health. Cash balances have increased significantly in the post-financial crisis years to levels last seen in the 1990s. Furthermore, corporate profitability in the second quarter of 2015 reached record levels {Source: Gavekal}. Dividend payout ratios have been increasing, although remain some way behind other developed markets, and share buyback activity has been buoyant, reaching new highs earlier this year.

The shift towards a more risk tolerant culture in Japan will take time, but importantly it is receiving proactive support through the so­ called 'Abenomics' programme. For example, effective April 2015, the Government Pension Investment Fund (GPIF) adopted a new policy asset mix to reduce the allocation to domestic and international bonds and increase exposure to domestic and international stocks. Furthermore, the GPIF announced in October that its international fixed income allocation was diversifying into emerging market and high yield bonds. Whether by default or design, Prime Minister Abe's popularity is being aligned to the fortunes of the stock market.

Japan is a market that is heavily exposed to the global economic cycle and we would caution that it could be vulnerable to further macro disappointments in the near term, especially if the Bank of Japan does not deliver further stimulus in October. However, in our view, over the longer-term, the cultural shift to increasing risk appetite and improving shareholder returns remain significant underpinnings.

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