The MSCI Japan Index is up 21.5% in local currency terms through March 31, 2013. It was easily one of the best-performing markets in the developed world during the first quarter. For US investors, however, that translates to a still-respectable 11.7%— a slightly better performance than the S&P 500 Index at 10.6% — when the impact of the weaker yen, down from 93 to 99 to a US dollar, is factored in.
To understand the bigger economic picture in Japan, it's necessary to examine the changes we're seeing — and, just as importantly, those we're not seeing. This is the second term for Prime Minister Shinzo Abe; his first term several years ago was not very successful. But he has now taken a much more aggressive stance toward fiscal and monetary policy than his recent predecessors had, resulting in:
- The recent installation of a more aggressive Bank of Japan (BOJ) governor, Haruhiko Kuroda. In early April, the BOJ initiated a new quantitative easing (QE) program that essentially doubles the size of its balance sheet over the next two years — a much more aggressive QE program than those of other central banks around the globe.
- A new target of 2% inflation within two years. While most economists don't believe Japan will be able to accomplish this, the target clearly indicates stepped-up effort.
In anticipation of these policies, the yen has weakened — down from 75 yen to a US dollar at the start of 2012 to 99 yen currently. The weaker yen has given export-oriented companies some much-needed breathing room.
To date, the government has made the easy moves — increasing government spending and printing more money. More importantly, however, the government, as in prior cycles, has yet to address the structural reasons for the economy's weakness. Their remedies so far are akin to taking aspirin for a broken leg — it might reduce the pain a little bit, but you still can't walk.
So let's look at the structural problems plaguing Japan's economy. They include:
- A declining working population shrinks about 1% per annum, and the aging retiree population is growing faster than the workforce. In addition, the aging population puts increasing pressure on government budgets for health care and social security spending and pension obligations.
- The ratio of government debt to gross domestic product has risen from 59% in 1983 to an expected 237% by the end of this year. Consequently, the debt service burden is rising.
- The tax system needs reform to generate government revenues.
- Japan lacks natural resources. The Japanese are net importers of food, oil, natural gas and other products.
- Japan's global competitiveness is declining because their productivity isn't keeping pace with the rest of the world. For example, South Korean electronics manufacturer Samsung, has replaced Sony and Panasonic as the global leaders in televisions. Likewise, Japan's global market share of shipbuilding has halved from 40% to 20% over just the past 10 years.1
- Finally, the government is increasing the consumption tax rate from 5% to 10% over the next two years, which will be a significant drag on an already persistently sluggish economy.
Given these structural problems, what sort of changes do we need to see in order to develop a more constructive view of Japan's economy and investment outlook?
- A change in corporate culture. We'd like to see increased focus on profitability, return on equity and return on assets. Also, managements must begin to recognize that they work for shareholders, rather than for employees.
- More efficient corporate capital allocation. Corporations need to reduce bloated balance sheets and increase dividend payout ratios and share buybacks. In addition, companies must stop investing in poor businesses with poor returns.
- Immigration reform. Japan has one of the tightest immigration policies in the world and has done little to alleviate the growing labor shortage. Some projections suggest that the Japanese population could fall from its current level of about 130 million to below 90 million over the next 50 years.
- Tax reform. The government has taken no steps toward increasing revenue.
- Reduction of debt. No plan is in place to cut Japan's ever-increasing debt burden.
Finding Japanese companies that meet our EQV (earnings, quality, valuation) criteria is challenging. Increased earnings expectations are all currency related at this point, and underlying improvements in businesses aren't apparent yet. In addition, return on investment remains quite low by global standards, and valuations for high-quality companies are currently excessive.
Brent Bates is a portfolio manager for Invesco International/global growth products. Read more about Mr. Bates.
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