What should investors make of Japan?

Its stock market has promised much but delivered little in recent years. However, there are a number of reasons why it might be wrong for investors to simply write off Japan.

When global economies recover, Japan tends to benefit from the pick-up in international trade, while a new, domestically-focused government offers the potential for much-needed reforms.

Japanese companies are used to dealing with the unusual challenges now facing western economies in the shape of a broken financial sector, high debt levels and near zero interest rates. In short, they have been through these problems before. Indeed, Japan seems to offer greater potential for positive surprises at a time when emerging markets look like a relatively expensive place to invest.

A divided economy

Japan officially emerged from a deep recession in the second quarter of 2009. The country was one of the biggest losers of the credit crunch when consumer demand contracted sharply around the world after the collapse of Lehman Brothers. Japan’s strength in exports proved to be its undoing as the global economies all turned down together.

The impact of the credit crunch on Japan underlined the lack of balance in the economy. Over the 2000-2007 period, virtually all of the growth in the economy was driven by exports1. This reliance on overseas markets exposed Japan fully to the savage reduction in global demand. The fact that the weak domestic sector offered such little protection has become a prime concern.

Exploding the myths of Japan’s bubble

Some investors will remember Japan’s ‘lost decade’ of stock market underperformance that followed Japan’s 1980s asset bubble (a period when equity and real estate prices surged to unjustifiably high peaks before crashing back to earth).

This was followed by another largely forgettable decade and the Nikkei currently sits around 10,300 having peaked just below 39,000 at the height of the bubble at the end of 19892.

Many experts use Japan’s damaging asset bubble experience to explain the lacklustre performance of its stock market. Popular opinion holds that the west has acted more swiftly and with greater conviction than Japan did. While this argument holds water, it is overly simplistic.

In truth, the Japanese authorities made use of fiscal programmes as well as introducing highly experimental monetary policy. In 1999, Japan became the first major economy to move interest rates to zero.

New Government offers promise on needed reforms

The landslide election victory of the Democratic Party of Japan (DPJ) at the end of August ended more than fifty years of almost unbroken rule by the Liberal Democratic Party (LDP). This was essentially a vote against the status quo, reflecting the people’s desire for change and more effective government.

We should not expect revolutionary change, as that is not the way Japan works. But, we can expect the DPJ to be more focused on the domestic economy and there are already plans to encourage consumer spending.

The lacklustre domestic economy is at least partly due to Japan’s unfavourable demographics where a small labour force supports an ageing population. The DPJ’s proposal to introduce generous child benefits is the first attempt we have seen in Japan to make a significant change to consumer incentives that could have a lasting, positive effect on the domestic economy.

The immediate reaction of the stock market to the new government has been muted. This is no bad thing.

When the popular Junichiro Koizumi was elected, the stock market rose sharply for six months in anticipation of reforms. However, it then underperformed for several years, as investors realised that his policies failed to address Japan’s underlying problem of low domestic consumption.

This time round, the market is more cautious, but that leaves room for growth if the new, domestically-focused policies can have an impact.

Look for domestic recovery in the small cap sector

The major Japanese stock market indices, like the Nikkei 225, do not really represent the domestic economy, since they are dominated by large, global exporters like Sony and Honda. Small companies are much more dependent on the Japanese consumer. Despite flat domestic consumption, smaller company brands, such as Uniqlo and Muji, have built up healthy market share.

Fortunately, the DPJ seems to understand that Japan can no longer sustain a large imbalance between its domestic and external sectors. Shrewd investors should look for signs of policy success in this area, not in the Nikkei 225 Index, but in the small company JASDAQ index.

An improved outlook for company profits

We are moving into a phase of recovering global growth; this is historically the time when Japanese stocks benefit from a pick-up in global trade. At the company level, the interesting aspect of the recent recession is that Japanese companies cut their fixed costs earlier, which may mean there could be positive surprises on earnings growth.

In fact, a range of companies, spanning the metals, auto and foods sectors among others, have shown a sharp recovery due to the success of their aggressive cost-cutting measures and a tentative pick-up in demand. This suggests that corporate Japan is on the road to recovery.

Conclusion

The outlook for Japan is interesting. Reinvigorating the domestic economy will not be easy. There is also the scope for political disappointment if the new government does not deliver. However, Japanese policy-makers and companies are experienced in dealing with many of the tough issues that their western counterparts now face.
On balance, there are reasons to be optimistic:

-Japan should benefit from the recovery in the global economy

-Japanese companies have the potential to deliver healthy profits

-The increased domestic focus from the government is encouraging – the policy on child benefit raises the prospect of real progress on the domestic economy

-Japanese shares look cheap when compared to certain emerging markets, which are beginning to look expensive on some measures.

Throw in the fact that most investors appear to have given up on the Japanese stock market after a series of disappointments, and this makes Japan a very interesting contrarian trade. Sometimes, the forgotten areas can be a profitable place to invest, before the crowd gets involved. Certainly, Japan is a market which investors should think twice about leaving out of their portfolios.

Tom Stevenson joined Fidelity in 2008 as Head of Corporate and Investment Communications. Tom has been a financial journalist for nearly 20 years, writing for the Investors Chronicle, The Independent and more recently the Daily Telegraph.

1. Source: Societe Generale Global Strategy, 15.09.09
2. Source: Thomson DataStream

Reference to specific securities should not be construed as a recommendation to buy or sell these securities, but is included for the purposes of illustration only. Investors should also note that the views expressed may no longer be current and may have already been acted upon by Fidelity. The ideas and conclusions expressed in this article are the author’s own and do not necessarily reflect the views of Fidelity.