But relative calm at the index level masked extreme divergence in sector and style performance. In particular, equity markets were characterized by high volatility and low liquidity. Momentum strategies and the most crowded stocks, as well as defensive companies with high profitability, high dividend yield and economically insensitive growth, outperformed by a wide margin. These patterns were most apparent at the sector level, as consumer staples, healthcare and utilities outperformed energy/commodities and technology by roughly 8% during the month. More generally, in style terms, growth completely dominated value, with the gap particularly extreme in the long-short products.
The US dollar strengthened against almost every currency, while bond yields declined across all regions. The most violent repricing happened in commodities. Energy was down by 18% to 21%, with broader commodity markets declining by 6% to 11%. Interpretations vary, ranging from lower demand in China to supply growth that was more persistent than expected. The oil price decline had a surprisingly mild impact on high-yield debt, which fell by less than 0.5%. Even though 15%–20% of outstanding high-yield debt comes from the energy sector, contagion has been remarkably mild.
History suggests that weaker oil prices and declining break-even rates are positive for equity returns. However, our risk-asset positioning remains very close to the benchmark (see Current Positioning section), despite increases in equity weights in some growth-oriented accounts. The most provocative decision concerns the energy and commodity complex, which struggled during July. As we’ve discussed before, we believe that the marginal cash cost of producing oil is around $35 to $40 per barrel, with the lower end of that range more relevant after the dollar’s strengthening. So, we plan to add exposure, either by selling put options or buying commodities/equities, once the price of West Texas Intermediate approaches $40 per barrel. At the end of July, we took advantage of the high volatility in gold mining companies by adding some exposure through the sale of out-of-the-money call options.
Our quantitative models continue to support an overweight in Japanese equities, while we’re underweight Japanese bonds. In this month’s report, we take a closer look at what will determine the success or failure of this positioning. We’ll also examine whether we should continue to hedge our exposure to the yen. In general, we think the current positioning should be maintained, but we conclude that relaxing the yen hedge makes sense.
Weaker Yen Contributed to Higher ROEs
Japanese equities have substantially outearned and outperformed their global peers since the Liberal Democratic Party, led by Prime Minister Shinzo Abe, returned to power in December 2012. The yen weakened sharply after the launch of Abenomics, a “three-arrow” policy of fiscal stimulus, monetary easing and structural reforms. As a result, Japanese businesses with global footprints enjoyed a substantial tailwind to profit margins, despite the relatively muted impact of the weaker yen on export volumes so far. At the same time, rising import prices helped break the deflationary trend in the domestic economy.
Following a fairly broad-based recovery in returns on equity (ROE) from depressed levels (with utilities and energy the main exceptions), aggregate ROE for Japanese companies is now close to its historical high (Display 1). Recent macroeconomic data have been mixed, and second-quarter gross domestic product (GDP) is widely expected to be weak. Concern is also rising over spillovers from a decelerating Chinese economy.
The direction of Bank of Japan (BOJ) policy from here is far less certain, and our base-case scenario is that the yen isn’t likely to depreciate much further. If the yen were to instead strengthen significantly, it could undo much of the progress so far in terms of overall inflation, corporate performance and sentiment. Meanwhile, Japanese equities are trading nearly on par with those of other developed markets on a price-to-forward-earnings basis. This indicates limited upside potential from the relative expansion of valuation ratios at current earnings levels.
So, is it time to trim our overweight to Japanese equities? We don’t think so.
Multi-Asset Funds Are Believers in Japan’s Recovery
As we see it, multi-asset funds are the true believers in a Japanese recovery, while equity funds have merely decreased their underweights to Japan.
Mutual fund holdings data reflect a fairly broad range of asset manager views and constraints. Multi-asset funds seem to believe in the potential for further recovery in Japan, while long-only equity funds remain underweight. Following Abe’s 2012 reelection, the median long-only equity fund meaningfully reduced underexposure to Japan, but holdings have remained fairly unchanged over the past year and a half (Display 2).
The median multi-asset fund reacted more quickly to the launch of Abenomics, moving from a significant underweight to a modest overweight in the following three quarters. The median fund is back to neutral exposure, but some larger fund managers are highly overweight, with 15%–20% equity allocations to Japan versus 8% for the MSCI All-Country World Index. Many of these managers were constructive on Japan even before the reelection, and seemingly remain so (Display 3).
This divergence of exposures between equity and multi-asset funds likely reflects the macro nature of the opportunity in Japan, as well as the greater ability/willingness of multi-asset managers to manage macro- and currency-related risks. It’s also worth noting that overall exposures are skewed somewhat downward by income-oriented funds, which have low or no exposure to Japan given lower dividend yields versus Europe.
Further Outperformance Requires Evidence of Structural Economic Changes
Our view is that Japanese equities continue to warrant an overweight, but the investment case has become more nuanced.
Until recently, investors only had to believe that depressed ROEs would recover through mean reversion, supported by the BOJ’s extraordinary quantitative and qualitative easing measures as well as fiscal stimulus. We think that trend has largely played out. We expect the next round of outperformance to come from Japan closing its substantial ROE gap versus its global peers. Our analysis suggests that Japanese companies could generate more than 30% excess earnings growth over the medium term by closing this gap.
A closer look at the last 25 years suggests that the ROE gap has been structural, not cyclical. As such, narrowing the gap requires fundamental changes in the way businesses operate. Why should this happen now? The rest of this report will explain why we believe Japan has the opportunity, motivation and will to succeed.
In a macro framework with nominal GDP growth equal to the sum of population growth, inflation and productivity growth, we believe that any upside surprise will likely come from productivity gains. Various structural measures of Abenomics target inflation and demographics; we believe that these are useful in setting as high a floor as possible on structurally deteriorating population growth, and in trying to offset deflationary pressures stemming from an aging population.
But Japan has a big opportunity to improve labor productivity relative to most other developed economies (Display 4), in our view. In the post–World War II era, countries including Japan, Germany and Italy started to gradually close the productivity gap versus the US. Both Germany and Italy achieved US-level labor productivity in the 1990s. Since then, Italy has lagged somewhat, but Germany has broadly kept pace with the US. In contrast, Japan’s productivity has stagnated at roughly 60% of US productivity since the early 1990s.
In a striking parallel, we find that the current Japanese ROE gap relative to the US is primarily driven by lower operating margins rather than below-the-line items, balance sheet size relative to sales, or leverage (Display 5). There are a number of causes for the gap that will be familiar to investors:
Lack of pricing power: Japan’s historically deflationary environment with falling wages hasn’t supported corporate pricing power in domestic markets. Meanwhile, exporters tried to avoid passing rising costs on to customers as the yen strengthened through 1995 and following the global Great Recession, instead sacrificing margins to preserve market share. One of the side effects has been the rise (until recently) of offshore manufacturing.
Excess labor: Given the rapidly rising unemployment in post-1990s Japan, the government and corporations prioritized employment security over operating efficiency, which is particularly apparent in domestic service sectors.
Lack of investment: The pre-1990s investment boom, excess labor, the movement of manufacturing overseas and a lack of optimism on future prospects have caused a sustained period of underinvestment by corporations that has only recently started to reverse. As a result, the average age of equipment in the manufacturing sector has steadily risen from 11.3 years in 1990 to 13.7 in 2000 to 17 today. This is well above the most recent US figure of 13 years.
Lack of focus: This may be harder to quantify, but we think it’s at least as important as the other drivers. The ROE spread vs. Japan’s global peers is narrower than average in the auto sector, where Japanese firms compete globally. In contrast, domestically oriented consumer companies have wider ROE spreads. It’s also intriguing that Japanese ROEs show much less dispersion across listed companies than those of US or European stocks (Display 6). This is likely because most Japanese companies don’t have explicit ROE or margin targets, in contrast to US and European companies.
Some Positive Signs Emerging
We now see signs of improvement in all these factors. So far, increasing labor participation and policies that encourage greater productivity and disciplined corporate capital use offer favorable signs for these initial steps turning into true progress.
With the help of quantitative and qualitative policy easing (QQE), inflation (as measured by the Consumer Price Index) returned to positive territory in mid-2013, following four years of broad deflation. Price expectations of consumers and businesses have recovered, while market-based inflation expectations currently range around 1%. As we face the possible tapering of monetary stimulus, the persistency of the inflation recovery will likely depend on wage growth and consumer confidence.
Admittedly, wage trends have been mixed so far. After accelerating for much of 2014, wage growth has been lackluster this year. The widely monitored spring wage increases likely benefited from government guidance, and were more encouraging. But there are concerns that these may not reflect broader underlying trends. Consumer confidence seems to be firming, but is somewhat below highs achieved following Abe’s reelection. However, we find some reassurance in what appears to be an increasingly tight labor market and historically low unemployment rates, which should support broader wage growth.
Over the past three years, the overall labor participation rate improved from 59.4% to 60.0%, compared to the US rate of 62.6% (Display 7). This upturn was driven by increased labor participation by females and across age groups, especially in the over-55 cohort. This increase partially served to offset the demographic headwind and resulted in only 0.3% growth in the overall labor force. Labor is likely to be in shorter supply as it becomes more difficult to raise the participation rate and demographic headwinds become stronger.
This presents a contrast to the experience of the late 1990s and early 2000s, when efforts by the government and businesses to fight unemployment led to bloated payrolls, contributing to the high cost structure we see today. It’s striking that the industries reporting the most severe labor shortages today are the ones with the lowest labor productivity (Display 8). As labor markets tighten, businesses will need to figure out ways to better use their workforces.
One way to improve productivity would be by increasing capital investment, an area that government policy also appears to be encouraging. In nonmanufacturing sectors, this may take the form of investment in automation and software. In fact, corporate investment in software in Japan, as a share of GDP, has modestly exceeded that in the US since 2002. Meanwhile, lack of capital investment in manufacturing has resulted in a rationalization of capacity and aging equipment. Further, given the yen’s depreciation, there are signs that Japanese firms may be “reshoring”—bringing manufacturing capacity back onshore. As a result, increased capital spending could help improve productivity long term, as well as create a source of domestic demand in the short term.
The most important catalyst in improving corporate profitability in Japan may well be the self-reinforcing set of guidance, incentives and control mechanisms the government has been introducing as part of its reform agenda. Policy documents articulate “encouraging corporate behavior to improve ‘earning power’ as a principal measure of the ‘Japan Revitalization Strategy 2015.’”
Some of the key actions the government has taken or encouraged have been:
- Introducing the JPX-Nikkei 400 Index, which features companies with high ROE, high operating profit and at least two outside directors, and which have adopted IFRS accounting standards and provide earnings reporting in English.
- The Government Pension Investment Fund’s increased allocation to domestic equities, which will use the JPX-Nikkei 400 for passive investment. The BOJ will also include this index in its quantitative easing purchase.
- A stewardship code that holds institutional investors responsible to “promote sustainable growth of companies through investment and dialogue.”
- The corporate governance code asking companies to set return-on-capital targets, appoint at least two independent directors, and disclose and explain the economic rationale for cross-shareholding.
- Reducing the corporate tax rate
In summary, the pension funds, the people they serve, and the government itself now have a vested interest in ensuring that businesses are managed efficiently and in a shareholder-friendly manner. Although it’s still early days, corporations appear to be responding. The share of companies with at least two independent directors has risen from 14% in 2010 to 46% today. Companies are introducing ROE targets, initiating buybacks and/or raising dividends, some with the explicit intention of being included in the JPX-Nikkei 400.
Japan’s Recovery Is Very Far from Riskless
The potential upside from the restructuring of “Japan, Inc.” is attractive, especially in the context of a global economy that seems broadly resigned to sluggish growth and depressed returns. But success is by no means certain. We’re monitoring six main sources of potential risk that could lead us to moderate our exposure:
Wage-price dynamics don’t play out as planned: If wage growth doesn’t make a sustained recovery or doesn’t translate into improved consumer confidence, it will limit top-line growth prospects as well as the potential for corporate margin improvement.
Firms use their balance sheets to overinvest in capacity growth or undertake value-destroying acquisitions: We view the policy push toward better use of corporate balance sheets as a positive. But it also creates the risk of pricing-power erosion if it leads to excessive capacity expansion instead of productivity-improvement measures. Similarly, an M&A spree by Japanese businesses could destroy value or distract management teams from operating-efficiency improvements.
Structural reform policies aren’t fully implemented: The declining approval rating for Prime Minister Abe is a cause for concern, because political turmoil would almost certainly interrupt the push for structural reform. We’re somewhat encouraged that the rating decline appears to be due to issues that aren’t directly linked to the economic reform agenda. In other words, a political changeover would hinder progress, but might not dismantle the entire investment case.
The yen strengthens significantly: As we discussed earlier, QQE has played a key role in jump-starting the improvement in corporate performance up to this point. We don’t expect much more yen weakening, but excessive appreciation, either from a BOJ policy mistake or a flight to safety, could result in a return to the deflationary spiral of the post-2008 era.
Insufficient demand for JGBs results in inability to fund fiscal deficit: This could be the most negative domestic source of risk for Japan. However, we find some reassurance in the primarily domestic ownership of Japanese Government Bonds (30% by the BOJ, planned to ramp up to 40%) and Japanese government assets that may offset some of its gross debt.
Global slowdown sets back recovery: Just prior to the Great Recession, the Japanese economy showed signs of improvement similar to what we’re seeing today. The global economic slowdown and yen appreciation as a result of the flight to safety severely impaired budding growth. That risk still stands today. It could come from excessive tightening by the US Federal Reserve or a bout of risk aversion from renewed uncertainty in the euro area. In a similar vein, decelerating growth in China may have spillover effects on Japan, but we view this more as a driver of medium-term volatility rather than as a structural negative for the investment thesis.
These risks notwithstanding, we see favorable asymmetry in the potential return profile for Japan versus other developed markets. Japan’s current 30% price-to-book-value discount to global markets should provide some valuation support. Although investor sentiment seems to have improved versus history, Japan is far from a consensus long position for institutional investors, as we discussed earlier in the report. Companies that take steps toward better corporate governance are being rewarded in the stock market. Both the government and the sizable pension system are increasingly vested in the success of corporate Japan.
We believe that these characteristics can start a self-reinforcing cycle that could speed the pace of corporate reform. We like achieving exposure through the JPX-Nikkei 400 Index, which may provide focused exposure to companies that show a commitment to improved performance and corporate governance.
We’ve modestly increased our exposure to risk assets. Related to the discussion last month, we closed out our negative position on oil by selling the put options. We’re maintaining a modestly procyclical stance, based on the assumption of a rebound in US small-business and household formation. Globally, we see relatively few deep-value opportunities, but the Greek crisis is starting to widen valuation spreads in Europe, the area where we have the largest value exposure. The key element to monitor is the continuation of credit creation, which is needed to sustain the recovery.