At the 71st CFA Institute Annual Conference in Hong Kong, Kathy Matsui, Chief Japan Strategist at Goldman Sachs, presented an in-depth look at the current state and future prospects of the world’s third-largest economy.
Let’s get started with some data. Since 2012, the USD/JPY exchange rate has gone from 86.5 to 107.1, nominal GDP has increased by 11.7%, the unemployment rate has fallen from 4.3% to 2.5% and corporate ROE has increased from 5.4% to 9.2%.
The Nikkei index has more than doubled over this period and outperformed the S&P500 and the STOXX 600 — an outperformance that was led purely by an increase in corporate earnings. The P/E multiples have actually fallen in Japan, from 18x to 14x, over this period of time.
The employment stats are a story in themselves. After graduation, 90% of graduates get jobs. This is against a background of increasing labor participation, especially among women and the elderly.
On average, there are 60% more jobs than job seekers. The ratio in some sectors, such as construction and caregiving, is even higher. Immigration may be one way to meet workforce needs. This is still a political hot potato, but there are moves to help overcome labor shortages in key sectors.
Another way to meet labor needs is by using robots instead of people. It’s a solution viewed with horror in most countries, but the rise of the robot is seen as viable option in Japan.
The tight labor market has resulted in a rise in the nominal total employment income, currently at an annual rate of 3.3%. This, together with domestic consumption that is 55% of GDP, has made companies cash rich. This cash has been returned to equity investors either by share buybacks or dividends, resulting in equity returns reaching new heights.
This is a strong story — why are investors not rushing into Japan? And why are investors still pricing these companies at a discount to book, highlighted by the fact that the TOPIX Index is at a 40% discount? Possible answers might be associated with traditional cross holdings, poor corporate governance, and large cash holdings that are not adding to growth.
But structural reforms are in place. Although Abe’s support has fallen recently, these will be ongoing and Matsui expects that they will build on the success of the last 6 years. If successful, they may change some of the negative beliefs and ease the employment situation, resulting in better valuation multiples. These reforms can be put into three buckets: corporate governance, women in the workforce, and fiscal.
Corporate governance reforms have led to an increased number of independent directors on boards. Today, approximately 90% of listed companies have at least three independent directors.
Ironically, this has been accompanied by an increase in the number of improper accounting treatment issues; this may indicate that increased independence makes improper treatment harder to hide. Good governance earns its own reward, which is reflected in the excess returns that have been noted when applying a basic ESG metric to company stocks.
Women are being encouraged to participate in the workforce through the increased provision of childcare facilities and an aim to eliminate daycare waiting lists. Although many jobs are part-time, a surprising fact is that more women work in Japan than the US. In Japan, more women are working than ever before.
Fiscal reform has focused on widening the tax net, and more importantly, collecting it! The country has a top marginal tax rate for individuals that is around 55%–60%, and one of Abe’s reforms aims to increase collection rates by rolling out a national individual tax ID program.
Additionally, 70% of companies in Japan have historically paid no tax. However, this may change if the government moves from taxing profit to taxing revenue. In the long run, these reforms will help make Japan’s high debt-to-GDP ratio more manageable.
So, it makes an interesting picture. Maybe it’s time to think again about Japanese equity?
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