Japanese stocks have experienced a rally in 2019, the Nikkei 225 index is up by around 18% so far, recently closing at its highest level in over a year. The broader Topix index is about 15% higher so far this year.
“Investors had been too negative on Japanese equities due to the concern over the impact of trade tensions,” Chisa Kobayashi, an analyst at UBS Global Wealth Management CIO, told the Japan Times. “We see Japanese equities having upside for next year on the back of a recovery in corporate earnings and international investors returning to the market.”
Although Columbia Threadneedle Investments earlier this year reduced the exposure of its Threadneedle Dynamic Real Return fund to the Japanese stock market, it still likes the nation’s equities.
"If we look at what is happening under the hood of Japanese companies, there has been a really meaningful shift that we want to capture," said Maya Bhandari, a portfolio manager at Columbia Threadneedle, told Investment Week.
"There is a real shift in the return on equity in Japan. Having waited decades for that to occur, the return on equity on Japanese stocks is today 10%, up from 3% to 4% over the last 18 months,” Bhandari added.
At BlackRock, the world’s largest asset manager, the view of the recent rally isn’t so rosy. “Japanese equities have outperformed, contrary to our expectations, thanks to a lull in trade tensions that we see as temporary,” chief investment strategist Mike Pyle told FE Trustnet.
“There is a real shift in the return on equity in Japan. Having waited decades for that to occur, the return on equity on Japanese stocks is today 10%, up from 3% to 4% over the last 18 months” - Columbia Threadneedle portfolio manager Maya Bhandari
“We do not see this rotation having staying power, though. In the near term, we see potential for further bouts of market volatility, as fallout from the trade war is reflected in weak economic data,” Pyle added.
A sudden breakdown in trade talks, some suggest, could wipe out the gains Japanese stocks have made this year, underscoring Japan’s vulnerability to trade headwinds.
Why is Japan vulnerable?
A generation ago, Japan’s economic growth was the envy of the world. There was even a point when it looked as if the country was on course to overtake the US as the world’s largest economy.
However, times change. At the start of the 1990s, following nearly half a century of strong economic growth following the Second World War, the asset bubble burst so spectacularly that in the almost 30 years since Japan, and its respective stock market, has not fully recovered.
In 2013, Japanese prime minister Shinzo Abe introduced a three-pronged package now widely referred to as “Abenomics”. This involved printing money to boost inflation and make Japanese exports more attractive; increasing government spending to stimulate demand and consumption; and introducing structural reforms to make the country’s companies and labour force more competitive.
Even so, Japan’s GDP has grown by an average of just 1% a year since 2013, is expected to be 0.9% this year, and will likely slow to 0.5% in 2020, according to the International Monetary Fund.
Meanwhile, the population is ageing as well as shrinking – a third of its residents are over 60 years old and birth rates have plummeted. The population is likely to be reduced by 25% by 2050. This means Japan’s government will be required to spend more on pensions as a reducing workforce leads to lower income tax yields.
Estimated population reduction of Japan by 2050
At the same time, several headwinds threaten to blow Japan’s economy off course, such as a rise in the domestic consumption tax, global economic uncertainty and trade tensions with South Korea – not to mention the current US-China trade war.
Cash is still king
Japan’s age dynamic also helps to explain Japan’s reluctance to move away from cash. At the beginning of 2019, 80% of purchases in Japan were still made with cash, compared with just 4% in South Korea, according to Reuters. Cash-handling exacerbates Japan’s productivity problems and costs businesses an estimated ¥1trn annually due to slower payment systems and less effective tax collection.
The cash-is-king mentality also applies to corporations, which have been hoarding their profits. “The Abe administration has been trying to lobby for higher wage growth and better compensation, but corporate leaders prefer to hoard cash and earn no return (interest rates are zero), rather than to invest in their employees,” said WisdomTree Investment’s Japan strategist Jesper Koll in the Japan Times.
To compound this, much of the country’s post-war economy was built on the tenet of lifetime employment. Although only 8% of Japanese companies offer such long-term prospects to employees, there are thought to be some 25 million workers aged 45 to 65 with outdated skills and who are paid disproportionately more than younger workers, undermining competitiveness and profitability.
Japan also has the highest national debt-to-GDP ratio in the world at 228%. However, this is financed by the Japanese government’s issuing of bonds, which are largely bought and held by domestic investors (mainly the Bank of Japan).
Japan's national debt-to-GDP ratio
Trade war on two fronts
Japan has been suffering from the US-China trade war. China and the US take in a total of 20% of Japan’s exports, and Japanese companies have historically invested heavily in China’s relatively cheap assembly lines.
It remains to be seen whether recent talks will bring conflict to an end. But according to a recent Reuters poll, 45% of Japanese firms have seen their profits affected by the tariff rises – a year ago just a third said they were impacted.
Percentage of Japanese firms whose profits have been affected by tariff rises
Closer to home, Tokyo is currently embroiled in a bitter trade war with South Korea.
In September last year, a Korean court ruled that Japanese companies must compensate the descendants of South Koreans exploited by forced labour during the Second World War. Japan has asserted that all claims were settled by a 1965 treaty.
Following the ruling, Japan introduced export controls on products used by South Korea’s semiconductor industry and downgraded Seoul’s status as a trusted trade partner. That led to a South Korean boycott of Japanese cars and beer.
A new dawn?
Some of Japan’s high-profile industries are forecast to have significant growth over the next few years, notably e-commerce and mobile payments. The expected influx of tourists for next year’s Tokyo Olympics led to investments in hotels and leisure, which have driven up capital expenditure by 1.5% this year, double what analysts forecast. Business investment is up for the 12th quarter in a row. The last-minute surge in retail demand ahead of October’s tax rise has also boosted the economy.
The Abe administration, in an effort to offset the 10% consumption tax, introduced a 5% discount on the tax for all payments made electronically. Since 1 October, Japanese supermarket chain FamilyMart [FYRTY] reported a 60% increase in cashless transactions and rival Lawson  saw a 50% jump in smartphone barcode payments.
But the last time Japan’s consumption tax rose, a pre-hike spike in spending was quickly followed by a slowdown and brief recession. In the next few months, the Japanese government might have to decide whether the economy needs another round of quantitative easing, which could negatively impact Japanese equities.