This is Japan’s moment of truth. Sunday’s election, whether premier Shinzo Abe gains a two-thirds majority in the upper house or, as appears more likely, he has to settle for a strong position just short of that, should give the country three election-free years. That will be one of the longest periods of political calm since the war. Meanwhile, the “third arrow” of so-called Abenomics is about to fire. Is there still value in Japan’s stock market?
An initial reaction is to scream “no”. First, there is the “Charlie Brown and the football” syndrome. Investors have had a tempting Japanese value proposition put in front of them many times since 1990. It is always pulled away leaving them on their back.
Second, there is the “tide is high” issue. Japanese stocks have rallied 42 per cent this year, in yen terms. Even in dollars, which make it look more similar to the US, Japan has beaten the rest of the world by some 18 per cent since Mr Abe’s arrival, according to FTSE indices. Jumping in when the tide has already surged in to this extent is seldom wise.
Yet there is a case to buy Japan. But it rests less on politics, and more on the corporate reporting season which is about to start, and it may rely less on Mr Abe and more on the earthquake and tsunami of early 2011. That human tragedy forced companies to restructure, slowly and unwillingly. We should now begin to see whether this can transform Japan’s profitability.
As the chart shows, Japan’s earnings have followed a fitful and erratic path over the past 20 years, particularly compared to the US. That is partly because the Japanese do not play the game of “shareholder value”, or attempt to maximise value for shareholders. But it also has to do with endemic over-capacity, while the sharp dip in recent years was driven by the disaster of the tsunami.
Jesper Koll, head of equity research for JPMorgan in Tokyo and a cheerful bull, points out that five years ago there were 11 major department store chains in Japan. Now there are four. This took out a layer of selling and administrative expenses, leaving them far more leveraged to a rise in sales.
By Mr Koll’s arithmetic, a 1 per cent increase in sales would once have driven a 10 per cent rise in profits; it would now push a 30 per cent profit rise.
Banks also benefit from gearing; they can still get away with zero interest on deposits, but the interest they can charge is growing nicely in response to rising loan demand – perhaps helped by post-tsunami reconstruction efforts.
Further, the yen has devalued in response to the first arrows of Abenomics, which involve aggressively lenient monetary policy. That boosts the profits of exporters, and should provide a catalyst.
Overall, the Topix trades at a multiple of 13.7 times 2015 consensus forecast earnings. If Mr Koll – or other Japan bulls with similar hopes – is right, then profits could be 30 per cent higher, which would still only be about 15 per cent above their high for the past 10 years. On this basis, the market is on a multiple of 10.4 times 2015 profits – and there is room for a drastic rise in prices.
While these trends pre-date Abenomics, its third arrow, if fired effectively, could accelerate this process. The next wave of changes, the hardest politically, involve structural reforms – a euphemism for measures that will hurt many, such as labour reform.
If the third arrow lands on target, then corporation tax will be slashed, from 40 per cent to somewhere closer to international norms, of maybe 20 or 25 per cent. That will directly boost companies’ bottom lines. Moves to make it easier to fire workers would also boost profits, as well as continue the process of reducing Japan’s excess capacity.
Cutting capacity would be good for stocks, and also fulfil Mr Abe’s aim of reviving inflation by restoring companies’ pricing power. What is good for companies and investors would not be so great for consumers.
There are still, however, plenty of risks, with the most significant lying across the China Sea. China accounts for more than 20 per cent of Japan’s exports, and more than the US. A slowdown at the worse end of current forecasts would be terrible news. A Chinese hard landing could also start a “risk-off” wave in markets, which would push up the yen, damaging exporters.
At home, the risk is that next year’s scheduled rise in sales tax from 5 per cent to 8 per cent is already accelerating the business cycle. Rising consumption could go back into reverse once the new tax rate comes into effect. Tetsufumi Yamakawa, Barclays’ head of research in Japan, suggests this could mean a fiscal contraction of as much as 1.5 per cent of gross domestic product – almost a Japanese “fiscal cliff”.
But the critical question is how much the cuts in capacity that have taken place so far have improved Japan’s endemic problem of poor profitability. Markets are betting that the consensus forecasts are pessimistic. Will Japan’s next earnings season prove them right?