The Bank of Japan’s (BOJ) surprise announcement that it would dramatically ramp up its QE efforts is a tacit admission that “Abenomics” is stalling, and supports our view about the underlying health of the Japanese economy: excessive debt levels, demographics, and overdue structural reforms are serious headwinds to growth.
To briefly recap, on October 31 the BOJ stunned market observers by announcing it would expand its asset purchases to ¥80 trillion per year, a considerable increase over the already-aggressive ¥60 trillion to ¥70 trillion target it had announced in April 2013. In conjunction, that same day the main government pension investment fund (GPIF) announced it would reduce holdings of government bonds and increase holdings of both domestic and international equities by around ¥21 trillion. These coordinated announcements lit their intended fire under Japanese stocks; a 4% gain on that day completed a rebound from what had been as much as an 11% drawdown through mid-October.
The BOJ may have felt compelled to act, as recent data suggested Abenomics was faltering in its attempt to boost growth and spur inflation. After a relatively robust first quarter, GDP growth contracted at roughly a 7% annual rate during the second quarter. The BOJ also may have been prompted by a sneak preview of third quarter numbers that, when released two weeks later, also came in well below expectations. Inflation too seems to be stalling; adjusted for the impact of the increase in the value-added tax in early April, core inflation has dipped back below 1%.
The first two arrows of Abenomics (fiscal and monetary) have numerous limitations given high government debt levels and interest rates that are already effectively at zero. Whether high inflation can ever be smoothly achieved in a country with massive debt levels is an open question; too much success on this front could spur capital flight. Still, one area where Abenomics has clearly worked is in weakening the yen; after another 11% drop against the US dollar in 2014 the yen has now depreciated over 35% since the start of 2012.
After a sluggish start, attempts at so-called third arrow (structural) reforms are starting to bear fruit, with important implications for investors. One example is the “stewardship code,” which many institutional investors have adopted and used to push for independent directors and higher shareholder returns. Another is the new JPX Nikkei 400 Stock Index, eligibility for which is determined by previous profit levels, historical return on equity (ROE), and corporate governance. Many companies are working to enhance these statistics and qualify for inclusion, as the GPIF and other local mutual funds and exchange-traded funds are targeting this subset of the market.
Even if improved governance requires more time to boost returns, in the meantime yen depreciation has massively boosted the value of foreign profits. Trailing 12-month Japanese corporate profits have more than doubled since the start of 2012 and Japanese corporate ROE (around 8%) has just surpassed that of European equivalents for the first time.
The surge in profits has not gone unnoticed by equity investors; while Japanese earnings have doubled since the start of 2012, so too has the stock market. Japanese stocks are now roughly 40% more expensive on a price-to-book basis than they were in early 2012. Still, the pace of appreciation has recently slowed and not kept up with earnings growth. Given a year-to-date 9% return (through November 20), the trailing price-earnings ratio has fallen to 16 from 25 at the start of 2013.
Notwithstanding recent developments, the headwinds to economic growth in Japan are sizable and extreme monetary policies increase risks. However, on a micro level, recent reforms hold promise for Japanese stocks, and the potential for earnings growth may not be fully reflected in valuations. Currently we suggest a neutral weighting for Japanese equities, but could foresee becoming more constructive based on relative valuations and earnings potential or if some of the macro clouds start to lift. Regardless of weighting in portfolios, we reiterate our longstanding advice to currency hedge Japanese equity exposure given the BOJ’s stated intent to weaken the currency.
Wade O’Brien is a Senior Investment Director on the Cambridge Associates Global Investment Research team.
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