In fairness, the expectation for Japanese equities to outperform isn’t without merit—given the stock market’s value/pro-cyclical tilt (the composition of Japan’s TOPIX market is roughly 60% value stocks and 40% growth stocks),³ Japan should theoretically benefit from the rotation to reflation/cyclical trades in a post-COVID-19 environment. In addition, Japanese equities were also widely perceived as being inexpensive and underowned by foreign investors. These factors should’ve been a recipe for outperformance; however, the asset class continues to underperform its global peers. From a macroeconomic perspective, we believe there are several reasons why Japanese equities have underperformed relative to expectation.
Japanese equities have underperformed their global peers since Q3 2020
1 Monetary policy is relatively tighter
Although the Bank of Japan (BoJ) is perceived as being stuck in perennial easing mode (the central bank is the biggest owner of Japanese stocks thanks to its exchange-traded fund (ETF) purchasing program⁴), the reality has been quite the opposite. Net additions to the BoJ’s balance sheet have slowed sharply since Q3 2020. The BoJ has also changed the composition of its asset purchases, reducing its holdings of Japan’s government bonds and equity ETFs while piling into short duration bank loans through its Loan Support Program.
Net additions to BoJ's balance sheet
This doesn’t look like quantitative easing
2 Fiscal policy is relatively tighter
Japan’s government has rolled out robust stimulus packages to help accelerate economic recovery worth 5.3% of the country’s GDP. Crucially, its fiscal package went beyond crisis management and included measures such as direct spending aimed at promoting digitalization, boosting software capability, reducing carbon emissions, and enhancing the country’s competitiveness.⁵ On a relative basis, however, the United States and the eurozone’s approach to fiscal spending was much looser. Crucially, Japan is forecast to enter a fiscal consolidation phase by running tighter fiscal policy from as soon as 2022⁶ which, in our view, risks short-circuiting the domestic recovery before it’s secured.
3 Japanese corporates’ free cash flow buffer has been run down
Japanese corporates ran a strong positive cash buffer in the post-global financial crisis period; however, the pandemic led to a sharp decline in corporate profits and has subsequently eroded their cash buffer, which has all but disappeared.⁷
COVID-19 has eroded profits and free cash flow in Japan
4 Japan’s corporate profits haven’t been as strong relative to the United States
Broadly speaking, we believe that the underperformance of broad Japanese equities, especially versus U.S. equities, can be explained by examining the level of corporate profits in both markets in local currency terms. After outpacing their U.S. counterparts on the earnings front for roughly four years, corporate profits in Japan became increasingly negative from Q2 2020.⁸
Corporate earnings: U.S. vs. Japan, in local currency terms
5 Limited room for sustained JPY depreciation
From a foreign exchange policy perspective, Japan has leaned toward currency depreciation since 2012, arguably to protect corporate profitability. However, with the Japanese yen (JPY) being undervalued by ~20% (relative to purchasing power parity), the room for sustained JPY depreciation appears limited. And as we’ve outlined in the latest edition of Global Macro Outlook, our peak macro thesis suggests the risks are tilted toward safe-haven JPY buying as we encounter pockets of market volatility and increased uncertainty, which would translate into increasing headwinds for corporate profits in Japan.
6 Rising political risk
As we mentioned in our Q3 2021 Global Macro Outlook, Japanese Prime Minister Yoshihide Suga and his cabinet’s approval rating have fallen to a record low⁹ ahead of the general election, which is due to take place by October. Factors that have weighed against popular opinion include the administration’s handling of the COVID-19 pandemic and its decision to go ahead with hosting the Summer Olympics this year. While the governing Liberal Democratic Party has a clear lead in the polls, which has been holding steady at around the mid-30% range,⁹ a leadership contest is set to take place in September—there’s a nonnegligible risk of a rival candidate coming to the fore who doesn’t subscribe to Prime Minister Suga’s reflationary policies.
Public support for the governing party has slumped to record lows (%)
Source: NHK, Macrobond, Manulife Investment Management, as of July 13, 2021. The gray area represents the period when public approval rating of the cabinet began falling.
7 Disaggregated performance of Japanese equities has been consistent with expectations
As a final point, we’d note that even though the recent underperformance of broad Japanese equities versus international equities may seem unusual relative to historical norms (Japanese stocks, broadly speaking, have historically outperformed their peers during global expansion cycles), a closer examination shows that Japan’s value/cyclical sectors have outperformed their growth/defensive sectors. Notably, the cyclical rotation into value has in fact been strongest in Japan.³ In our opinion, this provides further evidence that it pays to be much more selective when it comes to investing in Japan, and we continue to emphasise relative value as a theme in asset allocation.
1 “Warren Buffett takes $6bn bet on Japanese trading houses,” Financial Times, August 31, 2020. 2 “Is Japan the land of rising returns?” This Is Money, October 6, 2020; “Japanese stocks catch global investors’ eyes as post-COVID growth play,” Reuters, November 11, 2020. 3 Bloomberg, as of June 2021. 4 “BOJ Becomes Biggest Japan Stock Owner With $434 Billion Hoard,” Bloomberg, December 6, 2020. 5 “Japan announces new COVID-19 stimulus for economy,” BBC News, December 8, 2020. 6 “Fiscal Monitor: A Fair Shot,” International Monetary Fund, April 2021. 7 Cabinet Office (Government of Japan), Bank of Japan, Macrobond, as of July 8, 2021. 8 Cabinet Office (Government of Japan), Bank of Japan, Japan Ministry of Finance, Macrobond, as of July 8, 2021. 9 “NHK Survey: Support for Suga at lowest ever,” NHK World, July 12, 2021.
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
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