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Economic Insights

While heavily leveraged hedge funds pulled out of Japanese equities, some active managers have maintained a substantial exposure to Japan given a combination of attractive valuations and enticing long-term fundamentals.

After two “lost decades,” Japan took a page from the U.S. Federal Reserve’s playbook last spring by instituting a very aggressive monetary-easing program that triggered strong optimism that policymakers were finally on the right path. Between April 4, 2013, and May 22, investors around the world piled into Japanese stocks, fueling a 24% jump in the Nikkei 225, at which point some nervous players decided to take profits. One reason was the Bank of Japan (BoJ) had difficulty with volatility in the bond market and rates spiked higher (to 80 basis points [bps] from 40—50 bps) because liquidity dried up. There also was disappointment with Prime Minister Shinzo Abe’s June 4th speech on reforms and deregulation, which underscored the market’s rosy expectations ahead of July elections. Then came a global sell-off that added to nervousness about the world’s third-largest economy. But while a number of heavily leveraged hedge funds pulled out of Japanese equities, some active managers, including Lord Abbett’s international small cap, international core equity, and international dividend income strategies, have maintained a substantial exposure to Japan given a combination of attractive valuations and enticing long-term fundamentals. Here’s why.

Conditions looked fairly bleak for Japan in early 2011. Total debt as a percentage of gross domestic product1 was 226%—second only to the African nation of Zimbabwe and 3.8 times that of the supposedly “broke” United States.2 Japan had suffered through two decades of deflation, 14 prime ministers, a string of failed economic policies, a low birth rate, and a growing retiree population with medical and social security benefits that threatened to drive Japan further into the red.

Then came the credit-rating downgrades of Japan’s debt, followed a few months later by a catastrophic earthquake, tsunami, and nuclear disaster that plunged the nation further into despair.

Fast forward to the present, and one finds a nation of rising resilience and determination to implement bold fiscal, monetary, and structural reforms—whatever it takes—to finally get Japan on the right track. Is this time really different? We think so.

The big difference today is that if you look at all those past policies, none of them were focused on the structural issues that Japan has faced. Today’s proposals instead are a direct attempt to address those issues, and the key question now is whether Japan has the political will and the ability to pull itself out of its 20-year malaise. (See Chart 1.)


 
Chart 1. Biggest Japanese Stock Market Has Suffered a Long Decline

Source: Bloomberg. Data based on the Nikkei-225 Index, as of June 17, 2013. For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any specific investment.
Past performance is no guarantee of future results.

 

What’s different this time around? The first significant factor is valuations. If you look at where valuations are today versus history, and then factor in today’s resurgent yen rate (at less than—¥94.97/US$1, as of June 17, 2013), Japan trades on a forward price-to-earnings multiple3 of 14 times versus about 14 times for the United States and about 12 times for Europe, according to Mizuho Securities. But we would argue that earnings momentum and the earnings potential of Japan is likely superior now to what one would find in the United States or Europe.

The second difference today is that Japan actually has a stable political regime, ironic as that sounds for the world’s third-largest economy; stability concerns are commonly associated with emerging countries. Prime Minister Shinzo Abe, who was elected in December 2012, actually has an approval rating of almost 70%, one of the highest in the world, according to the Financial Times.

Given such political stability, we would argue that the Japanese market is likely worth more than current levels would suggest. That’s because a stable political regime boosts investors’ confidence and increases a nation’s internal ability to implement key structural reforms that have proven so elusive over the years.

The third difference in Japan’s current economic outlook, and arguably the most important, is a newly established consensus. Veteran Japan investors know that Japan is a consensus-driven society whereby decisions on complex issues can take a long time to agree upon and implement. But what many people fail to realize is that once consensus is reached in Japan, change can happen very quickly.

Today we find consensus on what needs to get done by the political institutions, the bureaucracy, the Bank of Japan, the media, and corporations.

For example, our team recently visited with Takahide Kiuchi, one of the more hawkish members of the board of governors at the Bank of Japan. (See sidebar.) For years, Kiuchi did not believe that aggressive monetary-policy easing would have any meaningful effect on the economy. Yet, on April 4, 2013, after the BoJ’s last meeting (the first under newly installed head governor Haruhiko Kuroda), an easing policy was adopted that was much broader in scope than anyone expected, thanks to consensus being reached.

Interestingly, the BoJ has taken a page out of the U.S. Fed’s playbook with a focus on pushing up asset prices, because it understands that such moves could create a virtuous economic cycle. The other focus, which is unique, is wage growth, something that has been sorely lacking over the last two decades.

To put the current initiatives (often called “Abenomics”) into perspective: between 2001 and 2006, monetary easing amounted to about 10% of Japan’s gross domestic product (GDP). The latest effort amounts to almost 30% of GDP in the next two years, according to Nihon Keizai Shimbun, a leading economic newspaper.

A Three-Pronged Policy
What enthuses investors now is Japan’s comprehensive focus on not just monetary policy but also fiscal policy and structural reform.

Japan’s extremely aggressive monetary-easing program is targeting 2% inflation over the next two years. From our perspective, we care less about whether or not officials achieve the 2% target over the next couple of years; rather, we care more about the actions they’re going to take to achieve that level.

Much of the current fiscal policy revolves around tax reform, and that’s taking many different angles. One is changes to the inheritance tax, which is already being implemented. That is an attempt to take capital from the elderly of Japan, from 20 basis-point4 deposit vehicles where the vast pool of assets sit, and recycle it to a younger generation who, it’s believed, can use it much more productively. And the government is actually incentivizing that transfer of wealth.

The second aspect of fiscal policy is corporate tax reform, with particular attention to lowering the cap on corporate tax rates, which are among the highest in the world. So, appreciable tax cuts would be a boost for profitability—and they also could potentially spur more capital spending and higher wage growth.

The final aspect of fiscal policy initiatives centers on trade. Japan recently announced that it has entered into broad trade talks with the European Union and, under an umbrella called the Trans-Pacific Partnership Agreement (TPP), the United States and countries in the Pacific Rim. It’s a long process, but a huge development, because the government is willing to go against some major constituents in Japan, particularly the agricultural lobby. This, in our opinion, is the proof in the pudding that Japan is moving forward.

In the meantime, changes in the political environment should lend support to a number of proposals that are on the table right now. With an upper house election this July, the expectation is that Abe and his party, the Liberal Democratic Party (LDP), will prevail, giving them control over both the upper house and the lower house of the Japanese parliament.

Many structural reforms are focused around labor. If such reforms were passed, the policies would restructure the temporary work force to make it easier for them to move into the permanent work force, and offer incentives to women to stay there.

Among other key structural reforms on the front burner are electricity deregulation, in order to get electricity costs down; the restarting of nuclear facilities, which are now shut down; and even the enhancement of individual savings accounts.

Japan’s individual savings accounts are similar to the 401(k)s in the United States, and there’s a push to get younger people with savings parked in low-yielding insurance vehicles to buy risk assets like equities.

While it may be too early to assess the progress of such bold policy actions, the stock market’s response has been encouraging. Since the BoJ’s aggressive monetary policy announcement in early April, the Japanese stock market, as represented by the Nikkei-225 Index,5 is still up 45%, even after a 17% pullback to catch its breath, according to Bloomberg. And trade liberalization also could increase GDP growth by just shy of 1%, which would be a substantial benefit for Japan.

As for the BoJ’s desire to boost inflation after a long bout with deflation, there are signs that the bond market is already factoring in increased prices.

Several members of Lord Abbett’s international team have visited Japan this year. We have seen real estate prices already going up—both commercial and residential. We’ve also seen a tremendous amount of liquidity come into the market, both domestic and international. Many countries in Asia and in Europe have been purchasing properties in Japan in the expectation that reflation will come back. Condo prices, in particular, are going up. Bank lending is growing again, for the first time in years. And mortgages are growing at 3% a year, another very good pace, according to Bloomberg.

Debt and Demographics
Encouraging as this sounds, some investors may still worry about Japan’s enormous level of debt that just keeps going up, and the enormous size of Japan’s elderly population.

We believe all this underscores the current sense of urgency in Japan. But as far as the debt is concerned, we take a somewhat more relaxed view, at least short term. Most of the debt in Japan is held internally, by the banks, by the post office (which is a quasi-national institution), and by local insurance companies. In fact, only about 5–10% of the debt in Japan is held outside the country, according to various credit rating agencies and financial news wires.

Another thing to keep in mind is that there is enormous asset wealth in Japan, and it’s not just at the personal level but also at the government level. Unlike heavily indebted countries that had to privatize certain infrastructure over the years, Japan hasn’t started selling off anything in terms of toll roads or airports. But there is plenty to choose from if the nation ever needs to raise funds to service some of this debt.

This is not to diminish Japan’s debt burden. We just believe Japan will be fine in the short term. Indeed, the best way to reduce a nation’s debt problem is to grow, and that’s what Japan is focused on.

As for the demographic issue, getting more women into the labor force will be crucial, since both the work force and the population are shrinking and a big increase in immigration is unlikely.

Against this backdrop, all three of Lord Abbett’s international strategies have maintained a substantial exposure to Japan given a combination of attractive valuations and enticing long-term fundamentals. The Lord Abbett international small cap core strategy's holdings are focused in the machinery and consumer sectors. The Lord Abbett international core strategy  and the Lord Abbett international dividend income strategy have holdings in auto manufacturers and other export-oriented companies in the industrial and information technology sectors.

Consider what the market has done since “Abenomics” started at the end of last year. The currency exchange rate has depreciated from ¥78 to ¥94.97/US$1. (See Chart 2.)


 
Chart 2. Since 1971, the Yen Has Steadily Declined Against the U.S. Dollar

Source: Bloomberg. Data as of June 17, 2013. For illustrative purposes only and does not reflect any Lord Abbett mutual fund or any specific investment.
Past performance is no guarantee of future results.

 

According to conventional wisdom, the biggest beneficiaries of such currency depreciation on the stock market would be exporters and technology and machinery companies, but that has not been the case. In fact, they’ve been laggards versus domestically oriented companies, including retail and financials.

In particular, we struggle to find technology stocks that we want to buy. Despite everything Japan is doing right now, these companies still face structural headwinds, and a weaker yen alone will not solve their problems.

As a result, Lord Abbett has oriented its international portfolios more toward those reflation areas where we’re already seeing tangible evidence of improvement, including real estate. Also, we own some select machinery companies that are not only beneficiaries of a weaker yen but are dominant in their respective product areas.

The bottom line is that as “Abenomics” progresses, Lord Abbett should be well positioned to take advantage of the changes that unfold, as our strategies have already been beneficiaries of a weaker yen.

Todd Jacobson, Lord Abbett Portfolio Manager, International Equity, joined Lord Abbett in 2003 from Warburg Pincus Asset Management/CSAM, where he was a Director and the Co-Manager of the International Focus Equity Product. In 2001, he was appointed Head of Japanese Equities (Tokyo), and oversaw CSAM’s primary Japanese equity fund and the Japanese research effort while living in Tokyo. His prior experience includes working at Brown Brothers Harriman as a Japanese Equity Analyst and as a Fixed Income Portfolio Manager. In addition, he was an Equity Analyst for Value Line, Inc. Mr. Jacobson received a BA in economics from the State University of New York at Binghamton and an MBA in finance from The Wharton School at the University of Pennsylvania. He has nearly 20 years of experience in the financial services industry.

Jump-Starting Japan

To underscore the significance of Japan’s very bold monetary-easing policy, Yoshi Hariyama, Director of Lord Abbett Asia, recently sat down with Takahide Kiuchi, a member of the policy board1 of the Bank of Japan (BoJ), whose key points are contained in the following question and answer session.

Q. There was institutional resistance to this kind of aggressive move. How was the Bank of Japan’s new governor, Haruhiko Kuroda, able to build such a consensus so quickly?
A. There were several factors:

• Six out of nine board members remain the same. Having worked together under previous BoJ governor Masaaki Shirakawa, consensus was easier to develop than if there had been significant turnover in this core group.

• The three new members are senior, especially Mr. Kuroda. The other two are deputy managing directors. The hierarchical structure of Japanese business culture promotes compliance with senior leadership. As with the U.S. Federal Open Market Committee, even though each member has an equal vote, the governor carries strong power within the board.

• All members have been in basic agreement in terms of a final goal of monetary policy, which is promoting the Japanese economy’s exit from a deflationary environment. Board members have long been discussing the methodology. Even if some members voted against the policy, differences were never hostile. It is common among board members to harmonize opinions, so that the meeting will conclude with policy that is supported by appropriate judgment.

• Each member clearly recognized that the last thing we should do was nothing or do the wrong things as a result of split opinions among members. This is why Mr. Kiuchi thought that he should accept the opinion.

• With Mr. Shirakawa, at the meetings in February and March [2013], discussion focused on the necessity of additional easing. Although Mr. Kiuchi personally believes that there have been positive effects by the policy conducted by Mr. Shirakawa, Mr. Kiuchi also understands that such effects have been minor. As a result, the Bank of Japan has been blamed for the deflationary environment in Japan and credibility was lost. After Mr. Abe was appointed as prime minister, all board members thought that we should work to improve the bad image of BoJ, and we believe we have made strides toward that goal.

• Mr. Shirakawa then declared his resignation. After he resigned, it was difficult for the board to implement any new or additional policy while knowing that a new governor would take over the position in March 2013. In this sense, all existing board members recognized that the chance for serious change would come when they would have the first policy meeting with Mr. Kuroda this past April.

• Also, Mr. Kuroda gave clear direction, in terms of roles for the BoJ, in his interviews, as well as in his testimony. It was not difficult for members to vote for his proposals.

Q. How explicit were political considerations in making a decision on this sensitive matter?
A. Clearly, the BoJ’s image problems had been building, making it a scapegoat for the bad economy in Japan. Prime Minister Shinzo Abe did not blame the BoJ directly, but he always mentioned its role and responsibility. The BoJ seemed to take this as pressure. Looking forward, Mr. Kiuchi said that the BoJ, after conducting new monetary policy, will likely apply some pressure to Mr. Abe to achieve his fiscal policy objectives. Also, Mr. Kiuchi mentioned that the BoJ should seriously focus on the discussion and implementation of increasing the consumption tax, which may adversely affect the economy.

Q. The size of the expansion is particularly surprising. In the 2000s, the BOJ expanded the balance sheet by ¥40 trillion to ¥110 trillion, less than 10% of GDP. This is more like 35–40%. How was that decision reached?
A. The BoJ has been conducting simulations with various models. There was no specific guideline to reach these numbers. It simulated movement of interest rates affected by purchases of Japanese government bonds [JGBs]. It simulated the increase in inflation by increasing the monetary base. It simulated the increase of asset value/price by both JGB purchases and monetary base expansion.

With such studies, however, the BoJ also considered the size of the impact it could have on the markets. It also thought that it would surprise the markets by this policy announcement.

Q. Is there an exit strategy?
A. There are several ways to answer that question:

• The BoJ thought it was important to announce and implement wholly the specific actions and goals of policy rather than introducing actions step by step. Every methodology under consideration has been already announced. As the governor mentioned in his interview, the BoJ would like to continue watching the progress for the next two-year period. At the moment, the BoJ is not considering any possibilities of additional actions. Nor is it ready to discuss any exit strategy.

• The BoJ will evaluate monetary policy from two different perspectives: the benefits and the costs of aggressive easing. The potential benefits are achieving a 2% inflation target, with sustainable economic growth, although Mr. Kiuchi personally still believes that it would be difficult to achieve a 2% inflation target within the next two years, despite his agreement with the policy statement.

• Since two years is a rather short time frame, the BoJ prefers to monitor inflation by watching the CPI ex food and energy.2 The BoJ believes it should not pay too much attention to short-term figures. For costs, the BoJ will pay attention to market values/prices of risk assets, such as stocks and real estate. The BoJ believes it should constantly watch the levels of values/prices of these assets, considering fair values, which the BoJ calculates by considering risk premiums.

• In general, we understand that implementing a monetary-expansion policy will eventually contribute to inflation. However, the BoJ is looking to achieve its inflation target through higher wages.

• The BoJ aims to increase the value of risk assets, which in turn would lead to growth opportunities for Japanese corporations. Although this will take some time, it is expected that, eventually, corporations will hire more permanent employees and increase their wages.

• The BoJ believes that the recent decision to increase bonus payments by relatively large corporations in Japan was not necessarily what the BoJ is looking for as a positive effect of the policy. The BoJ will keep paying careful attention to wage statistics and consumer behaviors.

Q. How will all this affect the value of the yen? Is there a target based on higher inflation?
A. The BoJ will announce no specific target values/prices of any assets or currency. Those should be determined by the markets. Mr. Kiuchi and other members clearly understood that the recent rapid movement of the yen is directly a result of the announcement of new monetary policy by the BoJ. Going forward, Mr. Kiuchi believes that there will be various issues, such as U.S. economic growth and the upcoming Trans-Pacific Partnership free-trade talks, which will affect the exchange rate. He also believes it is difficult to define an appropriate level that will allow Japan to achieve the 2% inflation target.

Q. What if aggressive monetary easing does not spur additional lending? What will/can the BoJ do?
A. The BoJ will behave as it announced in its policy statement:

• The BoJ will buy Japanese government bonds with longer maturities, such as five to 10 years. Theoretically, it will buy JGBs with maturities of more than 10 years as well. But the purpose is to achieve a seven-year average maturity3 of BoJ holdings.

• With this program of not only buying longer-term JGBs but also ETFs and REITs4 on the Tokyo Stock Exchange, the BoJ would like to boost the value of assets—a key to stimulating the economy.

• In this manner, the BoJ is going to take mainly interest-rate risk. With such an operation, the BoJ believes there will be less value for institutional investors to hold JGBs. The BoJ would like institutions, such as insurance companies, to shift their portfolios from JGB-oriented investments to riskier assets, such as equity and credit, in order to seek higher returns.

• In terms of the central bank’s lending activities, the BoJ will carefully monitor what will happen in banks.


1 Gross domestic product (GDP) is the total value of all the goods and services produced within a country’s borders. When that figure is adjusted for inflation, it is called the real gross domestic product, and it’s generally used to measure the growth of the country’s economy.
2 Source: World Bank.
3 Stock analysts calculate a forward price-to-earnings [P/E] ratio by dividing a stock’s current price by estimated future earnings per share. Some forward P/Es are calculated based on estimated earnings for the next four quarters, while others use actual earnings from the past two quarters with estimated earnings for the next two. A forward P/E may help you evaluate the current price of a stock in relation to what you can reasonably expect to happen in the near future. In contrast, a trailing P/E is based exclusively on past performance.
4 A basis point is one-hundredth of a percent, or 0.01%, with 100 basis points (bps) equaling 1%. Changes in the yields on bonds, notes, and other fixed-income investments are measured in basis points because they fluctuate regularly, typically by a few hundredths of a percentage point. For example, when the yield on a bond changes from 6.72% to 6.65%, it has dropped 7 bps.
5 The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange.


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