The Japanese equity market ran the range of investor emotions in 2016, as sentiment shifted from very negative early in the year, amid fears of a macroeconomic crisis, to positive later on, inspired by Donald Trump’s election in the U.S. and his pro-growth rhetoric.
A timely reminder of the highly cyclical nature of Japan’s equity market was delivered in 2016, as sentiment swung in lock step with changing global growth expectations. Optimism capitulated early in the year as weak oil demand, Chinese growth concerns, and deterioration in the U.S. credit cycle gave rise to fears of an impending macroeconomic crisis. However, just as sentiment was at its nadir, improvement in corporate earnings and economic activity provided a new impetus, spurring equity markets over the latter half of the year. Then, in November, in perhaps the biggest surprise of all, a Donald Trump-inspired, pro-growth sentiment rally took hold, fueling another leg of what has been a remarkable global equity market cycle.
However, while global equity markets ultimately posted solid gains in 2016, many investors remain unconvinced by the growth story that has been driving markets recently. Indeed, this opposing struggle between market bulls and bears has been escalating for at least two years, as the equity market cycle has matured, and looks set to remain a feature of the investment landscape over the coming year. This said, for those who see improvement in the global growth cycle, Japan seems to stand well placed to benefit in 2017–2018. Meanwhile, as mentioned in previous articles, Japan today is more than just a cyclical story, with market inefficiency and structural change creating real opportunity for investors willing to look longer term and beyond macro influences alone.
THE AGING BULL
In simplified terms, the current global equity bull market has largely been driven by three key factors: cheap initial valuations, falling interest rates/monetary stimulus, and an improvement in corporate profits from the lows of the Great Recession in 2008–2009. Nowhere have these driving forces been truer than in Japan. While the improvement in profits was slower to emerge, Japanese companies have proceeded to deliver superior earnings to almost all major markets over the last three years, and all at a lower market valuation.
This said, the environment described above has clearly evolved over the past two years, and this has brought uncertainty and bouts of volatility to equity markets, especially in Japan. Equity valuations are no longer visibly inexpensive, and the world economy has largely disappointed since early 2015, leading corporate earnings lower globally. Even the one constant throughout—the pattern of falling bond yields—has shifted more recently, with higher U.S. inflation expectations leading government bond yields higher once more. In many respects, the crucial questions today center on where the market improvement is real and where this will be most directly felt at the corporate earnings level, as well as which sectors appear most at risk of potential failure in 2017–2018.
Through some sharp swings in sentiment during 2016, we remained quietly optimistic about the global growth outlook, a view that has not changed today. While the political environment remains unpredictable, major economic indicators—wage growth, inflation, manufacturing, business sentiment—are all showing a positive trend, albeit some at seemingly glacial speed. While not particularly exciting, certainly relative to recent politically inspired euphoria, slow and gradual economic progress, interspersed with occasional disappointment, is an environment that historically has served investors reasonably well in performance terms. This is especially true for Japanese equity investors, particularly those willing to take advantage of attractive entry points into areas of structural improvement that have been beaten down by wavering cyclical confidence.
VALUATIONS REMAIN SUPPORTIVE
Across various valuation metrics, Japanese equities remain inexpensive relative to other major markets, on some measures noticeably so. This tends to indicate that not all of the good news in Japan is priced in to valuations, especially if optimistic about the outlook. Meanwhile, there is also a capital return story playing out in Japan that has been an enduring trend. Captured at the stock level, this could be a source of potential alpha while, at the market level, it has helped to drive ROE above that of Europe for the first time in nearly three decades. This represents real change at the corporate level, and it is starting to attract investor attention (See Figure 1).
Nevertheless, it is worth noting that the strong progress made by global equity markets since the U.S. election has created opportunities, but also risks, particularly within more economically sensitive market areas. While fundamental indicators were already generally improving, investor attention since November has largely been focused on growth prospects being supported by politicians. As valuations have risen to reflect this hope, there is a genuine risk of disappointment emerging during 2017 should the reality fall short of the rhetoric.
OPTIMISTIC BUT SELECTIVE
Along the spectrum that separates the best- and worst-case scenarios currently being presented for Japan, our expectations for 2017 fall somewhere in the middle of the two extremes. From a currency perspective, we feel the yen is now at a point that reasonably reflects both the current state of the Japanese economy and where it is headed in the near term. Also, the recent Trump-inspired ebullience aside, there does appear to be a real and positive shift evolving in the world economy. Our conviction in this view is directly reflected in our portfolios, where we are overweight stocks that are cyclical beneficiaries at the earnings level, especially in the export-sensitive precision instruments sector. We are also positive about certain parts of the domestic economy, such as the information technology services sector. At the same time, we are happy to pass on some of the large-cap market segments—particularly banks and autos—currently attracting significant investment flows, largely as a result of passive and exchange-traded fund capital allocation. In these sectors, we do not believe that the backdrop of overcapacity, efficiently priced stocks, and a lack of pricing power has changed materially simply as a result of the new U.S. administration.
During times of economic and market transition, capital flows will often move stock prices faster than fundamentals, and it can be difficult to avoid being swept up in the sentiment that feeds such a shift. Indeed, the traditionally higher volatility of the Topix Index, relative to other major indices, partially reflects Japan’s exposure to short-term trading and transient money flows. Accordingly, an important element of long-term success in Japan is the ability to be carefully contrarian through these extreme periods.
Our investment approach applies this spirit at its core, looking at the Japanese market with a long-term lens and focusing principally on changes—and their magnitude—in corporate earnings power over time. In this way, we are better able to filter out a lot of the nonfundamental “noise” that tends to influence markets in the short term and instead focus our attention on quality, reliable businesses that can deliver over a market/economic cycle. Our portfolio is constructed around these “growth compounders”—companies we see delivering earnings growth as a result of fundamental change, including more efficient capital allocation via increased share buybacks and dividends. This trend toward greater returns paid out to shareholders has been increasingly evident among Japanese companies in recent years. This provides a real opportunity for investors looking for more from Japan than just a cyclical global growth proxy and who also want a degree of cushioning when macro speed bumps inevitably arise.
GOVERNANCE AND SHAREHOLDER RETURNS ARE IMPROVING
A significant influence in this regard has been the government’s commitment to achieving market reform. Representing the “third arrow” of Prime Minister Shinzo Abe’s “Abenomics” strategy, the aim is to deliver improvement across a broad range of corporate and workplace issues. It is in the area of corporate governance that perhaps the most tangible evidence of progress has been made, with the development and publication of new governance and stewardship codes. Subsequent actions by companies, delivering more shareholder-friendly policies and increased transparency, have created real positive change that is not yet fully recognized by the global investment community.
As a result of Mr. Abe’s direct influence, and by utilizing the might of the Government Pension Investment Fund to invest in more shareholder-focused businesses, Japanese companies posted an all-time high level of share buybacks in 2016 (Figure 2). This increasing level of capital returned to shareholders is in stark contrast to previous periods of corporate health, when profitability and rising free cash flow levels notoriously led to stockpiled cash balances and lower ROE levels. New highs in total capital returned to investors was also achieved in 2016, and in our view, this shift in corporate focus is enduring. Increased dividends, more share buybacks, and less idle cash (earning zero or negative returns on balance sheets) are all positives for prospective returns. This is also encouraging for valuations, as investors will invariably pay higher multiples for companies that are improving their capital allocation and shareholder return policies.
If the past 12 months have taught us anything it is that, before all else, Japan remains a highly cyclical economy, and this tends to be directly reflected in equity market volatility. It has also confirmed the importance of being selective, with an active, forward-looking investment approach. With Japan’s investment landscape effectively swinging full circle during the course of 2016, we believe that we are now roughly in the middle of the extremes of the past year. Investors have taken some pain, but as we look ahead, we see reasons to be optimistic again. In short, the outlook for Japan in 2017 is encouraging for patient investors who are selective and who focus on high-quality export-oriented businesses and companies exposed to the strongest areas of the domestic economy.
Archibald Ciganer - Portfolio Manager - T. Rowe Price