Every time there is a negative headline about Japan, the American media–particularly The New York Times–writes the entire Japanese economy off. This has been happening for decades and we’ve consistently been wrong, leading to a dramatically reduced understanding of how competitive Japanese companies really are. In the most recent case, Japan has tilted into a recession and Prime Minister Abe has called a snap election. I’m seeing headlines about how the word “Japan” has become a one-word euphemism for all the slow growth and economic mismanagement we’re seeing in so many countries. But Michael Casey, writing in today’s Journal, gets it right:
This is no time to sell Japan.
If ever there were a contrarian indicator, it’s the fatalism ingrained in nearly all analysis of the Japanese economy. “Japan” is now a metaphor for the dangers that all debt-laden Western economies face. And with this week’s news that it slipped back into recession last quarter, prompting inevitable charges that “Abenomics” has failed, the Japan-is-doomed line pervades all commentary.
But let’s face it, there is nothing new in acknowledging Japan’s structural challenges. We’ve been talking about its aging society, deflationary trap and gargantuan debt load for two decades. All of that is in the price. In fact, notwithstanding the GDP disappointment, there are reasons to believe Prime Minister Shinzo Abe ’s “three arrows” of monetary stimulus, fiscal stimulus and structural reform are working. Stock investors should take note.
Abenomics already has boosted Japanese equities, of course. But by various measures, Japanese companies are still cheap. The Nikkei-225 index is up more than 19% since mid-October, mostly on account of the Bank of Japan increasing its asset purchases. But the distorting effect of the subsequent weakening in the yen is evident in the fact that the dollar-denominated MSCI Japan index posted only a 6.7% increase over the same time, barely half of the 13% rise in the S&P 500. Also, whereas U.S. stock averages are at records, the Nikkei is still less than half of its 1989 peak.
Valuation-wise, the Nikkei trades on a price/earnings ratio that is slightly higher than the S&P’s, but on a trailing price-to-book basis Japan is far cheaper—1.67 for the Nikkei, versus 2.8 for the S&P. Many analysts believe this gauge, which measures companies’ market capitalization relative to net assets, is better than a P/E ratio for assessing cross-country market valuations because different countries’ accounting methods can distort profit results and forecasts.
According to Yu-Ming Wang, global head of investment at Nikko Asset Management, which has $168 billion in assets under management, more than 40% of Japanese companies have a price-to-book ratio of less than one. While those low expectations reflect the fact that investors “have been disappointed a couple of times too many,” it is also a buying opportunity, says Mr. Wang. What makes this time different, he says, is that “Abenomics has reinvigorated Japan.”
Among various “third arrow” changes, improvements to corporate governance, including establishing independent boards and incentive-based compensation plans, are creating a “shareholder friendly culture” that is helping Japanese companies’ boost returns on equity, Mr. Wang says. He notes that in just one year of existence, the JPX-Nikkei Index 400, which comprises companies that comply with international governance standards, is far outperforming the rest of the market, encouraging laggards to lift their game, too.
Reforms at the giant $1.1 trillion Government Pension Investment Fund also will spur more equity investment. The GPIF will now be allowed to invest in riskier assets beyond the government bonds in which it was previously concentrated. And according to a Wall Street Journal report Tuesday, it will soon appoint internationally trained Hiromichi Mizuno, a partner at London-based private-equity firm Coller Capital, as its first ever chief investment officer.
Surveys show household inflation expectations are rising, a sign that the BOJ’s monetary easing and the weak yen are breaking the back of deflation and ending the disincentive to save. There’s even hope for solutions to Japan’s aging society problem: Mr. Abe’s “womenomics” measures, for one, are creating incentives for women to join the workforce, widening the productive base and offsetting the drag from retirees who leave it.
Meanwhile, Japanese companies are dispelling the myth of an inability to innovate and compete with low-cost producers in South Korea and China. Japan is leading the world in robotics, medical imaging, fuel cells and solar energy, for example.
What’s more, the recent slide in oil prices provides a de facto tax cut for an economy that’s highly dependent on the important fuel—a useful offset to April’s actual sales-tax increase.
Even that controversial three-percentage-point tax increase, which produced two quarters of unwelcome economic contraction and led Mr. Abe to call a snap election—he also postponed implementing a follow-up increase—can be seen as a necessary evil. Keynesian economists such as Paul Krugman say tax hikes impose a growth-killing burden on a fragile economy, but the fact remains that Japan’s public debt is worth 240% of GDP. Given the importance of steering Japanese savings out of public bonds and into either consumption or riskier assets, the government must widen the tax base if it is to safely manage that giant debt load.
In other words, the tax increases are integral to the broader economic restructuring campaign, Abenomics’ most important mission. Given a chance, that mission might just succeed.