Japan: Is this time really different?

Investors are heading to Japan … but questions remain over its economic credentials.

Summary: The Japanese stockmarket has surged this year, thanks to the aggressive economic stimulus program co-ordinated by the Bank of Japan aimed at reviving the nation’s sluggish economy. Opinions on Japan’s economic recovery are divided, and that became apparent at a conference this week run by the global investment bank UBS.
Key take-out: Japan’s companies had to become lean to survive during decades of stagnation, so any earnings growth coming from exports and a devalued yen should flow right to the bottom line.
Key beneficiaries: General investors. Category: Economics and strategy.

Last week, UBS’ gathering of leading chief investment officers proved a bit of a snooze, until the panelists perked-up on the topic of the Japanese stockmarket.

It was nice to hear them bicker amidst all the day’s uniform pleasantries. Some of the strategists worried that Japanese equities were little more than a momentum trade, which would ultimately turn around, while others seriously liked the medium-term prospects of Abenomics, the nomenclature for Prime Minister Shinzo Abe’s attempt to revive the sluggish Japanese economy.
Graph for Japan: Is this time really different?

UBS is largely siding with Abe and has invested significantly in Japanese equities since May, when it began advising that its clients build that position, now at an outsized 28% of their allocation to international developed stocks’ 8.5% of the model portfolio’s total. UBS’ other overweight allocation is to US stocks, 21% of the overall portfolio, as explained in Rubber duck investing.

The two positions are similar, explained UBS Wealth Management’s Alexander Friedman, the global CIO, and Mark Haefele, its head of investments; both are driven by an improving economy and significant monetary easing. “We think that for better or for ill, the story going forward is one of central banks,” said Haefele. “The Fed is going to taper at some point in the near future, but that’s not in the cards for Japan.”

The Bank of Japan is taking extraordinary measures, triple the Fed’s efforts in proportion to the Japanese economy, so coupled with policy action, Haefele and Alexander think these measures will ultimately end the deflationary spiral and feed consumer optimism. Expect upside earnings surprises. Japan’s companies had to become lean to survive during decades of stagnation, so any earnings growth coming from exports and a devalued yen should flow right to the bottom line.

Even though the Nikkei is already up about 40% this year, Friedman and Haefele still like export-oriented Japanese companies, due to the weaker yen and their prediction that a capital expenditure revolution is coming, an event not seen in 20 years. The twosome also like Japanese financials because they are levered to the cyclical recovery. Essentially, as the economy begins to recover so do the loan portfolios and hence profits of banks.

Vadim Zlotnikov, chief market strategist for Alliance Bernstein, kicked-off the Japan debate when he said his top-performing six-month investment play would be domestically-oriented Japanese companies – rather than their exporting counterparts – because the domestic stocks are trading at a relative discount.

But disagreement quickly became apparent. State Street’s Lacaille said though his firm is slightly overweight Japan, questions remain about whether the significant monetary stimulus will feed an economic recovery. For him, it’s a question of the Bank of Japan’s credibility. Can they reach their inflation target of 2%, currently at a lowly 0.9%? “If in two years’ time inflation isn’t above 2%, the question becomes what is the plan B? As we approach that two year time frame, the debate might get increasingly fractious and that could make investors nervous.” The intermediate returns are at best choppy, he said, and while there’s a little bit of opportunity, it’s not a very large one.

Perhaps most interesting was the disagreement between UBS’ Haefele and Curt Custard, UBS’ head of global investment solutions. As noted, Haefele is bullish, saying that the prospects of Abenomics are not yet priced into the market, at 16 times next year’s estimate for the Nikkei versus 14 for the S&P.

Custard, however, was deeply sceptical that the Japanese are truly getting their act together. “I covered Japan as my first job out of college,” he said. “I’ve heard ‘This time it’s different’ about five different times in my career and have been suckered into at least a few of them myself.” Over the past 20 years, Japan’s stockmarket and economy have languished in an extended period still dubbed the “Lost Decade.”

Custard listed the ongoing structural challenges: an ageing population, low birth rate, and many corporate governance issues – companies are still wary of returning cash to shareholders. Plus, remember to factor in mountainous debt levels, he said, now at a stratospheric 230% of GDP. “They have known about these issues for 20 years and yet address none of them.” His advice was to be very careful about piling into the Japan momentum, and don’t underestimate the cultural impediments. Unfortunately, Haefele was not given ample time to respond.

Elsewhere in the conference, however, there were a lot of “kumbaya” clap-alongs. There was overwhelming agreement that the debt ceiling debates would continue to gyrate the markets; US equities would continue to be top performers, in particular small caps and financials levered to economic recovery; and that European equities are fundamentally undervalued against US equities, but watch the bank stress test in 2014 for a buying opportunity.

In short, other than Japan, where real disagreement existed, there was a disconcerting amount of agreement. So much so, that Rick Lacaille, global CIO at State Street Global Advisors, warily added, “We’re all looking for contrarian themes, because we know it drives returns, but the thing that scares me a little bit about this panel is the alarming consensus.”


This article was first printed in Barron’s, and is reproduced with permission.