Stay the Course to Japan's Rewards

In recent years, Japan has transformed from the “ultimate contrarian play,” to the poster child of equity market recovery and outperformance. The prospect of positive change offered by Abenomics, as well as a real recovery in corporate profits, attracted meaningful flows into Japan’s equity market, says Archibald Ciganer, Portfolio Manager, Japanese Equity Strategy at T. Rowe Price.

In April 2016, T. Rowe Price published a paper titled "Japan — After the Love Has Gone" — detailing their view that the Japan equity thesis was in transition and recommending an active approach, given the expectation of further uncertainty in the near term. Over recent months, the Japanese equity market has indeed demonstrated above-average volatility, with significant switches in sentiment commonplace. Given the evolving market environment, both in Japan and globally, it seems prudent to revisit T. Rowe Price's original investment thesis and reassess the fundamental case for Japanese equities.

The Ultimate Contrarian Play that was
In 2012, T. Rowe Price labeled Japan as the “the ultimate contrarian play.” At the time, Japanese equity markets were characterized by extremely weak investor sentiment, a fact reflected in valuations that touched multi-decade lows. Along with improving global economic sentiment, the principal catalyst behind the turnaround was the introduction of Prime Minister Shinzo Abe’s self-help economic plan, so-called Abenomics. The “three arrows” strategy—monetary stimulus, fiscal stimulus, and structural reform — proved instrumental in fueling a renaissance in investors’ perception of Japan. With renewed hopes of positive long-term and cyclical change, meaningful flows poured into Japan’s equity market.

However, more than three years later Japan remains at an economic crossroad. Despite unprecedented
monetary policy, in terms of size and scope, the intended impact has been uneven at best. Japan’s economic growth profile remains subdued, inflation elusive, and broad-based wage growth — the key to reviving consumption — yet to accelerate. While Japan shares this growth dilemma with many peers, most notably Europe, the question remains whether it is at the beginning of a period of lasting change or just at the end of a period of temporary relief.

Stronger Yen, Weaker Yen — Why it Matters so much
The direction of the currency, and the advantage that a weakening yen has provided since 2012, is one element of the investment thesis that has clearly shifted, at least for now. The strong appreciation over the past year has been a surprise, especially the magnitude of the strength. Even direct action by the Bank of Japan (BoJ), intervening to cut interest rates into negative territory — a move specifically designed to weaken the currency — has failed to contain the appreciation. Drivers of this change include renewed focus on the yen as a perceived “safe haven” currency during times of global market volatility. Similarly, the abandoning of yen-hedging positions as capital has been withdrawn has also had an impact. This latter trend should dissipate once outflows slow and a degree of stability reasserts itself on the equity market.

The value of the yen is especially important given that Japanese equity market returns have become increasingly (inversely) correlated with the currency (see Figure 1). While the dominant influence of the yen is proving challenging for investors, volatility in the currency has created wide dispersion in stock
returns. This environment undoubtedly offers opportunity and, in Archibald Ciganer's view, necessitates an active approach focused on sifting through the volatility to find durable companies unduly penalized during periods of weak sentiment.

Go Big or Go Home — Doublingdown on Policy
In response to rising domestic and international growth concerns, the BoJ has expanded the breadth of its policy, initiating negative interest rates on banks’ excess reserves and also providing increasing support to its domestic equity market via exchange-traded funds (ETF) purchases. However, the policy expansion in 2016 has not had the intended impact, with the yen continuing to strengthen and investor sentiment turning sharply downward. Rather than the hoped for improvement in consumption, negative rates have heightened concerns about the profitability of Japan’s banks and sent a clear signal from the BoJ that all is not well in the progression of the economy. As the equity market has shown weakness (see Figure 2), the BoJ has responded with force, expanding its own purchases of Japan equity ETFs to try and support the market and prove its conviction.

Fuel up the Helicopters?
One positive to emerge from this period of uncertainty it is that policymakers in Japan have been reminded that the effectiveness of monetary policy alone is finite and ongoing support via the other “arrows” of policy will need to be maintained. Accordingly, in late July, Mr. Abe announced a fiscal stimulus package aimed at boosting the domestic economy. While debate rages about how much of this package amounted to new stimulus versus spending that was already planned, it nevertheless
underlines Mr. Abe’s authority and ability to apply policy measures in a world where many political establishments are under renewed and, in some cases, extreme pressure.

Certainly, the majority of Japan’s population desperately wants Mr. Abe to succeed, the electorate reaffirming his mandate in July 2016 with a significant win in the upper house. The victory ensures that his Liberal Democratic Party maintains control of both the upper and lower houses of parliament. For
those who believe the prime minister has made progress, however uneven, this is a positive in terms of maintaining the foundation from which Abenomics and, in turn, Japanese equities, can progress.

While easier fiscal policy is also being discussed in Europe and the U.S., Japan is the first major economy to adopt such a “double-down” policy approach, and highlights Mr. Abe’s commitment to delivering the promises laid out in his Abenomics strategy. The planned hike in sales tax, due to commence in April 2017, has wisely been delayed while spending on growth initiatives has been raised. Speculation has also arisen that the BoJ may introduce some form of “helicopter money”— essentially expanding the money supply to pay for infrastructure spending, or to enact direct transfers to the public (thereby cutting out the banking system transmission issues apparent with quantitative easing) — with the aim of stimulating spending and inflation.

While this remains an extreme measure, for better or worse, the commitment to deliver economic growth and improvement for Japan remains intact. Indeed, proof of this commitment was confirmed, albeit in a surprising new direction, by the BoJ at its September 2016 meeting, announcing a change
to its stimulus program in the hope of spurring economic growth. While the Bank kept interest rates unchanged, it set a new target of maintaining yields on 10-year bonds at 0% levels. Negative interest rates in Japan have put the financial sector under tremendous pressure, so by maintaining 10-year yields at 0%, the BoJ is providing support for Japan’s beleaguered banks, insurance companies and large pension funds, in the hope that improvement in the financial sector will flow through to the broader economy.

Japanese Equities are Cyclical
Exogenous factors have been a significant influence on Japanese equities in 2016, largely related to a
weaker global economic backdrop. It is worth reiterating that the case for Japanese equities relates to global economic factors as well as the prospective Abenomics-driven selfhelp story. Corporate earnings are particularly sensitive to global economic conditions, more so than any of Japan’s developed world counterparts. With the global economic backdrop stagnating in 2016, uncertainty has taken a toll on Japanese sentiment and the equity market. While initiatives by policymakers continue to target an improvement in the domestic environment, unless coordinated global policy can spark an improvement in weak global demand, then broad Japanese equity indices are likely to remain impeded to some degree. T. Rowe Price's own global outlook remains one of modest but stable growth, an environment that should provide the opportunity for Japanese equities to at least arrest their recent weakness versus global peers.

Certainly, after the pullback we have seen so far in 2016, the valuation case has started to reassert itself. Relative to other major equity markets, Japanese equity valuations remain at the widest margin from peak 2007 levels (see Figure 3). Of course, this will not shield Japan in the event of a significant downturn in global growth. However, such an outcome is not T. Rowe Price base-case scenario. Accordingly, T. Rowe Price views current valuation levels as an appealing entry point for investors, especially those who remain optimistic about the ability of the global economy to surprise on the upside.

Corporate Profits Recovery — Exceptional, but Fading
Central to T. Rowe Pirce's positive view over the past three years has been the real recovery in corporate profits. While Abenomics has stolen the headlines, the recovery in company profits has been the fundamental fuel that has driven Japan’s equity rally since 2012 (see Figure 4). The improving profitability trend has also been a unique feature compared with other major markets. Certainly in the case of Europe and, to a lesser extent, the U.S., stock market gains have generally been driven by multiple expansion/valuations rising, rather than by improving profits. However, with the global outlook weakening in 2016, the momentum in Japanese corporate profit growth has waned, at least for now. On a market-wide basis, profit growth is likely to be broadly flat over the next fiscal year, with downside risk to this view if the yen remains strong. This slowing profit growth has been quickly priced into the market, hence Japan’s underperformance so far this year. Accordingly, companies that can continue to generate profit growth in the current environment will likely be rerated higher on the back of high investor demand.

At a market level, two trends have emerged in direct response to the weakening environment. First, T. Rowe Price are seeing increasing dispersion in stock returns. Second, more attention is being given to shareholder returns (via improved capital allocation and corporate governance). In the current lower-return environment, capturing these instances of positive change is even more significant, but it calls for an
active and forward-looking approach.

The Third Arrow and Corporate Governance Reform
Structural reform is the key “third arrow” of the Abenomics strategy, targeting improvement across a broad range of issues, spanning gender inequality in the labor force, tax reform, energy sector monopolies, and corporate governance. This last area is where tangible progress has been made, with the prime minister showing unexpected determination to ensure the development and publication of corporate governance and stewardship codes. Resultant actions by companies to deliver more shareholderfriendly policies have created real positive change.

As a result of Mr Abe’s rhetoric, and by utilizing the might of Japan’s Government Pension Investment Fund to invest in higher profitability, more shareholder-focused companies, Japanese corporates are on track to record an all-time-high level of share buybacks in 2016. This return of capital to shareholders is in stark contrast to previous years, when profitability and rising free cash flow levels notoriously led to stockpiled cash balances and lower return on equity levels. New highs in total capital returned to investors are also likely to be reached in 2016, when factoring in dividend returns (see Figure 5). In Archibald Ciganer's view, this shift in corporate focus appears more enduring. Increased dividends, more share buybacks, and less idle cash (earning zero or negative returns on balance sheets) are all positives for prospective returns. This is also encouraging for valuations, as investors will invariably pay higher multiples for companies that are improving their capital allocation and shareholder return policies.

Stay the Course
T. Rowe Price continues to anticipate further volatility and increasing dispersion of stock returns as the investment thesis surrounding the Japanese equity market evolves. While Japan’s place as a cyclical equity market implies a greater level of volatility than its peers, it is not the only market that is transitioning through a period clouded by heightened uncertainty. However, the injection of fiscal stimulus, alongside existing monetary policy, marks a significant shift in strategy for policymakers and should prove supportive for the equity market and Japanese consumer, if afforded time. In addition, while the BoJ’s ETF purchases are relatively small, they are significant from a sentiment perspective and driving more stock-specific volatility across the market.

Given the need to be selective and cognizant of market volatility, exposure to Japan still needs an active investment approach. While the smooth pattern of positive returns over recent years has
provided much comfort, the current environment remains an appealing one for patient investors who can filter out the “noise” and find durable, improving businesses capable of weathering global economic turbulence, as well as companies exposed to the best areas of the domestic economy. Given attractive
valuation levels, and the many pockets of growth and improvement still present in Japan, T. Rowe Price remains constructive.