Clouds hanging over the Japanese markets to disperse

Key takeaways
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Japanese stock markets have been losing steam and underperforming major developed markets after hitting a renewed 30-year high in February.
In contrast, corporate earnings growth has gathered momentum as Japanese manufacturers capitalise on the rising demand for goods amid limited out-of-home activities and a recovery in the global economy.
As a result, the valuation gap between Japan and the developed economies has been expanding (Figure 1).
Source: FactSet, data as of 31 July 2021
Nevertheless, non-Japanese investors remain sceptical about Japan and underweight the country. A delay in vaccine rollout and economic reopening has been often cited as the reason behind it. But this has been partly because Japan was relatively successful in living with Covid-19, without halting economic activities.
The accelerating vaccination rollout will ease economy opening uncertainties
While Delta variant spreads are a concern like elsewhere, the death toll has been rather contained thanks to high vaccination rates among the elderly. Vaccination rollouts have been progressing in line with the government plan to inoculate all residents willing to do so by October-November (Figure 2).
Source:Our World in Data, data as of 15 August 2021
The recent Tokyo Olympic Games was another potential cause for concern. But spectators were banned, and the competition unfolded smoothly. Local athletes owned the stage and won a national record numbers of medals. In our opinion, uncertainties have eased, and a full reopening should be within sights. With household savings currently rising amid restraints on social activities, the reopening should unleash domestic consumer spending in Japan later this year.
Japanese companies have continued to enjoy significant earnings improvements and the April-June quarter aggregated operating profits have recovered to the pre-pandemic levels in the same quarter of 2019. We expect Japanese companies to continue to exploit the recovery in global GDP through exporting or manufacturing high-end materials and products overseas (Figure 3).
Source: Bank of Japan, data as of July 2021
Source: Ministry of Economy, Trade and Industry, data as of June 2021
On top of that, given its relatively large exposure to the capital goods sector, a resumption in capital expenditure that was delayed during the pandemic should also help propel corporate earnings in Japan later this year. Against these backdrops, we expect such sustained earnings growth to trigger a rerating of Japanese stocks and performance gap to narrow.
Corporate governance reforms changing the ways of companies
From a longer-term perspective, corporate governance reform remains a secular trend since former prime minister Shinzo Abe introduced it in 2014.
Last June, the Tokyo Stock Exchange (TSE) released the second revision to the Corporate Governance (CG) Code. This revision is tied in with the TSE reform that will take place in April 2022, which primarily aims to attract capital by providing investors with a market consisting of stocks that have sound governance and sufficient liquidity.
The revised CG code itself remains a “comply or explain” soft law, but it now sets a higher governance standard for the companies that want to be listed on the new Prime Market on the TSE. Under the reform the Prime Market will replace the TSE First Section.
Japanese companies have had strong reputational incentives to be on the TSE First Section and will strive to meet the new Prime Market requirements. One of the Prime Market listing governance codes to be introduced is that independent directors must make up at least a third of board members of a company. Since last year, on the TSE First Section this has increased from 58.7% to 72.8% as at 14 July 2021 (Figure 4).
Source: Tokyo Stock Exchange, “Appointment of Independent Directors and Establishment of Nomination and Remuneration Committees by TSE-Listed Companies”, data as of 2 August 2021
It should also be pointed out the Prime Market standards will also include English disclosure, which has often been an obstacle for foreign investors when they look at Japanese companies. Meanwhile, there are no major changes in principles related to capital efficiency this time.
That said, the number of Japanese companies adopting capital efficiency for their business targets has been rising steadily and shareholder returns have been trending up since 2014 (Figure 5). While the pandemic temporarily dented the last fiscal year’s buybacks, the Japanese companies have resumed share buyback programmes along with the earnings growth back on track.
Source: Goldman Sachs based on companies’ consolidated cashflow statements, data as of 11 August 2021
Sustainability practices in companies expected to improve
The new code steps up requirements to deal with social and environmental matters. For example, Japanese management remains predominately Japanese male lifetime employees. To solve workplace diversity problems, the code requires implementing policies, setting key performance indicators (KPI) and disclosing progress to ensure workplace diversity in terms of gender, nationality and mid-career hiring.
This produces the trickle-down effects on asset managers’ stewardship activity, where their proxy voting guidelines are to include the board diversity from the next annual general meeting (AGM).
Furthermore, commitment to sustainability rises in importance in the CG code principles. Japan already has the largest number of companies supporting the Task Force on Climate-related Financial Disclosure (TCFD) (Figure 6).
Source: Task Force on Climate-related Financial Disclosures, https://www.fsb-tcfd.org/supporters/, data as of July 2021
For Prime Market listed companies, the TCFD or equivalent quality disclosure framework is required to accelerate constructive dialogues on climate change between companies and investors.
The Japanese government has committed to achieving carbon neutrality by 2050 and the number of companies setting carbon neutral targets have increased. For instance, Hitachi sets an ambitious target to achieve carbon neutrality by 2030. This is much earlier than the government target.
Currently, the Japanese economy still relies on fossil energy, with a lack of immediate green alternatives that are economical or technically feasible. Therefore, transition finance is moving to mainstream finance business to bridge the gap and enable to achieve the long-term climate objectives.
In the longer term, this energy transformation should open opportunities for an increase in environment-related innovations and investments. For example, Japan is the top contributor of patent filing in hydrogen fuels and batteries according to the Ministry of Economy, Trade and Industry*.
In addition, Toyota Motor supplied zero-carbon emission hydrogen-powered fuel-cell vehicles to the Olympic Games and has started to compete in a 24-hour endurance race with such zero-emission cars.
While the Japanese equities have fallen out of favour, Japanese companies have been achieving a robust recovery from the pandemic. From now on, they are poised to capitalise on the resumption of capital expenditure and economic reopening on top of the on-going global economic recovery.
Moreover, from long-term perspectives, Japanese companies have been slowly but surely making progress in corporate governance reform as well as social and environmental challenges. Given these on-the-ground developments, we believe the cloud hanging over Japan should disperse.
Join our webinar
"ESG in Japan: Progress and opportunity in a rapidly evolving corporate and societal landscape?" next Thursday 26th August at 10AM BST featuring Daiji Ozawa, CIO of Japanese Equities. The webinar is for residents in the UK, Isle of Man, Jersey and Guernsey.
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Data as at 18/08/2021, unless otherwise stated.