Global Market Commentary

October 10, 2013

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More Reasons to Be Bullish on Japan

We believe recent events and emerging trends continue to justify a bullish position on Japanese equity markets.

Since the Japanese economy has been trapped in deflation for more than two decades, the psychology of Japanese market participants — from individuals to corporate managers — had become deeply skeptical of investment in equities. This is perfectly rational in a deflationary environment in which simply sitting on cash yields a riskless, positive return.

The Nikkei Has a Long Way to Go to Reclaim its 1989 High

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Soucre: Wikipedia

Changing the Deflationary Psychology of Individuals and Companies

We’ve read about the opinions of individual Japanese savers that buying equities is like gambling — a sentiment that many Japanese learned at their parents’ knees. This culture of skepticism manifests in many ways. As of March this year, equities made up just 7.9 percent of Japanese household wealth, versus 15 percent in Europe, and 34 percent in the United States.

Further, the cash that Japanese households have not invested in equities comprises a huge pile indeed — about ¥800 trillion, or about $8 trillion in cash and cash equivalents. It is essentially ‘under the mattress’. The total market capitalization of the Tokyo Stock Exchange, for comparison, is about ¥420 trillion, or $4.2 trillion.

Of course, it’s not just households that have accumulated cash. Japanese companies have also hoarded cash, and for basically the same reason that households have. Of course, they have also been hesitant to make capital expenditures in the stagnant economy that deflation generated — so cash reserves have grown faster than capex. In the first quarter of 2013, cash held by private Japanese non-financial firms was about ¥225 trillion, or $2.3 trillion — the most since record-keeping began in 1979.

As we can see, the Bank of Japan is far from being the only relevant actor in this drama. Japanese companies and Japanese consumers hold the real key to the appreciation potential of Japanese equities.

Abe’s Goals

Shinzo Abe, Japan’s prime minister, has had a purpose since his election in December of last year. The purpose he has voiced is to break deflation, but his deeper purpose is to liberate Japanese savings so that they can be invested in the Japanese economy. In order to accomplish this goal, Abe’s administration (as well as a compliant Bank of Japan) is instituting policies that make investment more attractive than hoarding. If successful, their efforts will create real inflation, and thereby move cash out from the mattress and into riskier assets such as equities.

The TOPIX Index has risen 65 percent since Abe’s election in November. However, the rally may still be in its earlier stages if his policies succeed in changing Japanese psychology and bringing savings into the market.

Is Inflation Happening?

Abe has made some progress towards his inflation-creating goal. As we noted recently, prices in August rose 0.8 percent year-over-year, although most of this increase was due to food and energy increases (due to the weakening purchasing power of the Yen for imports, and the emerging energy crunch which we have explored). Strip out those volatile elements, and consumer prices fell by 0.1 percent. As we will note below, this reality is certainly not lost on the Bank of Japan, and we believe that it will be spurred to further monetary easing as a consequence.

However, Japanese consumer psychology is certainly being impacted by higher prices. This is doubly true because so far Japanese corporations have not responded to Abe’s urging to raise wages (more about that below). In August, Japanese wages saw a year-over-year drop of 0.6 percent.

A Coming Positive: the Introduction of Nippon Individual Savings Accounts (NISAs)

On the individual side of this equation, just recently the Japanese government has introduced tax-privileged individual savings accounts, modeled on similar programs in the U.K. (ISAs) and the U.S. (IRAs). The incentive for the individual to participate is the expectation of inflation — which although currently at a moderate level is already convincing individual savers that they will be losing money if they let their cash sit idle. At current inflation rates of 0.8 percent they now face a real negative return with Japanese bonds (which currently provide the lowest returns of any government bonds in the world, at a 10-year rate of 0.68 percent as of September 27). The Japanese government is strongly communicating their strategy that they will not stop pushing inflation up until it reaches 2.0 percent.

Now, these new NISAs (which we described earlier this year when they were first proposed) are available, and 3 million Japanese have filed applications for them according to financial firm Nomura. Under this program, each individual will be able to purchase ¥1 million (US $10,400) in equities each year through 2018 — and pay no tax on dividends or capital gains. A recent survey found that 65 percent of respondents would transfer funds from their bank accounts (where they are now losing value) into NISAs.

Eligible instruments for purchase under this program include stock investment trusts, individual stocks, ETFs, and REITs — but not government or corporate bonds, or bond funds.

Very Bullish for Japanese Equities

Nomura estimates that between ¥28 trillion (US $290 billion) and ¥68 trillion (US $710 billion) will go into NISAs during the next five years. At the midpoint, that would represent more than 10 percent of the total market capitalization of the Tokyo stock exchange.

For most of the past decade, Japanese investors have been net sellers of equities — to the tune of ¥21 trillion during that period. They have largely missed out on the rally that has happened since Abe’s election, and the new taxes and new savings accounts seem set to persuade them that they should not miss out on ‘Round Two’ of a bull market in equities.

Capital Gains Increase May Create Buying Opportunity

Capital gains, currently taxed at 10 percent, are due to increase to 20 percent at the beginning of next year. The fact that the capital gains tax is set to rise may cause a short-term sell-off in equities as investors lock in the lower rate on currently unrealized gains. A survey conducted by Nomura found that 23 percent of individual holders of equities said they would sell equities held in normal accounts, and replace them with NISA holdings. If this sell-off occurs, we would regard it as a buying opportunity for Japanese equities, since the adoption of NISAs and steadily increasing buying will likely ensue in the new year.

The Corporate Perspective

Individual Japanese savers are not the only ones with a huge cash pile about to be virtuously “encouraged” into the equities market. Japanese companies, made lean by long years of deflation, and wary of capital investment, have also been accumulating cash. What will they do with this cash?

Share Buybacks and Dividends? Yes.

One use to which corporate cash is now being put is share buybacks. Goldman Sachs estimates that share buybacks may reach ¥3.8 trillion (US $40 billion) in the fiscal year ending next March. In the first half of 2013, TOPIX companies repurchased ¥1.8 trillion of their own shares — 0.66 percent of the index’s total value. 

In other words, Japanese companies are not selling into the current rally. They’re buying. We view this as a bullish sign for equities, since the insiders who are buying are certainly the ones who know best what their companies are fundamentally worth. And they do not believe that their equities are overvalued. Japanese companies are apparently convinced that inflation is coming, and that holding equities is preferable to holding cash which will decline in value.

Companies are also increasing their dividends, which are expected to rise 8.7 percent in the current fiscal year.

Increasing Capex? Not Yet.

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Source: 13D Research

They could also make capital investments; but largely, they aren’t. As can be seen from the chart below, the ratio of capital expenditure to cash flow is still far below pre-crisis levels:

This is a sign that while Abenomics is indeed breaking the deflationary mindset in corporate Japan, corporations have not yet been convinced that reinvestment in expanding plant and equipment will produce greater value for shareholders. So while share buybacks are bullish short-term, a more sustainable medium-and long-term rally in equities will require more substantive reforms to encourage forward-looking optimism in Japanese companies. This is the territory where the further policy shifts — Abe’s “third arrow” — become critical.

Sales Tax Increase

One such policy with a potentially negative effect will be a sales-tax increase. The increase, from 5 to 8 percent, will take effect next April, and was enacted by the previous administration. After much speculation, Abe announced last week that it would go ahead. This will be a blow to the economy, which it estimated will contract at a 4.5 percent annualized rate in the following quarter, and resulting in an estimated annual growth rate of 1.6 percent versus 1.9 percent for the current year. (To keep this in context, the city of Los Angeles, California has a state and municipal sales tax rate of over 10 percent.)

It was, however, a bitter medicine that Abe’s administration had to ingest in order to secure the continued confidence of international financial markets. With a national debt now in excess of a quadrillion Yen (U.S. $10.4 trillion), and at 245 percent of GDP, the highest level of debt in the developed world, Japan can’t afford only to think about stimulus — it also has to think about its creditworthiness in investors’ eyes. Moody’s took the government’s willingness to go ahead with the increase positively. Likewise, the International Monetary Fund emphasized that failing to go ahead with the increase would indicate that Japan might be ultimately incapable of getting its fiscal house in order. Various analysts have suggested that the sales tax would ultimately have to rise to 15 or even 20 percent in order to move towards substantive “fiscal adjustment.”

The government’s economic minister did note that if the perceived effects of the hike were too dire, the next incremental step — from 8 percent to 10 percent in October 2015 — could be delayed or abandoned.

The government is also providing a stimulus package — about ¥5 trillion, over US $50 billion — to cushion the blow. We think it is likely that more support may come from further action by the Bank of Japan.

Further Easing Down the Road?

If the impact of the tax increase is damaging, the Bank of Japan may act to take further action under its mandate of achieving a 2 percent inflation rate.

Though he has so far declined further action, Governor Haruhiko Kuroda has suggested that the Bank stands ready as necessary to increase monetary stimulus in response to a slowdown. Some observers believe that since Kuroda has not acted since the big easing announced in April, and since he has a preference for fewer significant moves rather than many incremental moves, this means a greater likelihood of significant action from the Bank in response to the risk posed by the coming tax hike.

Corporate Taxes and Wages 

Although the immediate effects of individual and corporate cash entering equity markets support our bullish view of Japanese stocks in the near-term. The “third arrow” of structural reforms will probably improve the Japanese economy as they are gradually implemented.

Several sources described plans shaping up for corporate tax reform, although they are not yet finalized, according to government ministers. It’s proposed that a temporary increase in the corporate tax rate, currently in effect, be terminated at the beginning of the 2014 fiscal year — one year earlier than planned. A further set of tax breaks for the current fiscal year is also under consideration. Together these would reduce the effective corporate tax rate from 38 percent to 35.6 percent next year.

The critical ingredient, though, is wages. As long as consumers are being squeezed between rising costs and wages that are shrinking in real value, their spending will not be the engine of growth that Japan needs. Japanese companies are apparently not yet convinced that the stock market upturn will lead a real upturn in demand. Only 13 percent of companies surveyed by Reuters said that they would raise wages in response to next year’s sales tax rise.

Long-Term, Wait and See; Short-Term, Make Hay While the Sun Shines

The medium-term prospects for Japan hinge on Abe’s further reforms — tax reforms and encouraging more participation by women are two that are high on his list — as well as on a psychological shift of corporate Japan towards greater capital expenditure and higher wages. We are waiting and watching to see how those movements progress. However, in the meantime, as far as the Japanese market is concerned, we believe that policies already enacted will continue to drive the market higher over the intermediate term.

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