This article first appeared in the Telegraph
It doesn’t pay to underestimate Japan, as Ireland recently found to its cost in the Rugby World Cup. When the country puts its mind to it, there is not much it cannot achieve. Having dispatched Samoa on Saturday, an unexpected progression to the latter stages of the tournament it is hosting is now in its own hands.
Taking its place at sport’s top table may prove easier than maintaining its ranking in the global economy. The last time Tokyo hosted the Olympics in 1964, the Japanese miracle lay ahead. Now, as Japan gears up for the 2020 event, its ageing population and deserted countryside can feel like yesterday’s story in an otherwise vibrant region.
Like another small island nation with a difficult relationship to its powerful continental neighbour, Japan is struggling to find its place in the post-globalisation world. Its principal challenge today is to manage the contradictory imperatives of boosting a stagnant economy while at the same time managing down one of the world’s most crippling debt burdens.
Last week’s VAT hike from 8% to 10%, with a host of offsetting measures to limit the damage of the higher consumption tax, is the latest challenge in this two-way battle. The fact that it is being implemented four years later than planned underscores Tokyo’s ambivalence about balancing its books and funding an increasingly geriatric society while simultaneously trying to overcome a generational deflationary slump.
The Government’s nervousness about increasing the tax burden is understandable. When it last hiked the consumption tax from 5% to 8% in 2014 it knocked more than 7% off GDP. It was hoping to reach its 10% tax target in 2015 but postponed it once to 2017 and again to the beginning of this month. Even now, it is proposing a raft of offsetting stimulus measures to ensure that a domestic slowdown doesn’t compound the external trade pressures that are already squeezing Japanese exports.
It is right to tread carefully. Domestic demand is what is keeping Japan above water this year as its manufacturing and services sectors diverge. A tight labour market, rising wages and a buoyant tourism sector are offsetting the collateral damage of the US-China trade war. Along with Germany, Japan is one of the most exposed countries to slowing global trade.
The real impact of the VAT hike will not be known for a few months yet because the telegraphing of higher prices meant that many purchases were brought forward to take advantage of the lower tax rate while it remained in place. In the main, the boost has been felt in a sharp rise in fast-moving consumer goods - there’s been a boom in toilet paper and baby wipe sales, for example - but surveys of willingness to buy big-ticket durable goods also point to a nasty hangover over the next six months.
Japan has been out of favour for the past year or so with overseas investors as trade war fears have compounded an existing cyclical downturn in its key areas of industrial strength - machine tools and technology components. Both are extremely volatile markets, with fairly predictable cycles. The good news is that they look close to bottoming out. 2020 could be much better on both fronts than 2019 has been.
The ramping up of 5G phone deliveries - all Apple phones from next year will be 5G enabled - could have a big impact on Japan’s component makers. The new phones will need much greater battery power too. These trends are already showing up in the performance of Japanese IT stocks and contributed to the outperformance by the Japanese stock market in September.
Overall, earnings forecasts are expected to be trimmed thanks to the combined impact of the tax hike and trade war. The effect will be compounded by a likely rise in the value of the yen, a traditional safe haven in times of economic uncertainty. Yen strength is likely to be accentuated if the political situation in the US deteriorates. A rising yen is typically bad news for the Tokyo market because it makes Japan’s exports less competitive and its overseas earnings less valuable on translation back into the Japanese currency.
That’s the bad news. The good news is that this subdued outlook is more than factored into Japan’s out-of-favour market valuation. Japanese shares trade on around 12 times expected earnings. That’s almost as cheap as they got in the wake of the financial crisis in late 2008 and again after the Tohoku earthquake in 2011.
Not only are Japanese shares cheap versus their own history, they are also cheaper than their counterparts in the US, Europe and the rest of the Asia Pacific region. The gap is particularly noticeable when measuring share prices against companies’ assets thanks to the preponderance of cash on cautious Japanese businesses’ balance sheets.
The cash piles at many Japanese companies’ disposal are a misunderstood attraction. They are funding a surge in share buybacks, forecast by Nomura to rise more than 50% this year, taking total shareholder returns to another record in the year to next March.
The fourth quarter has started nervously for understandable reasons. From Hong Kong to the Middle East, geo-political risks are a concern. Politics on both sides of the Atlantic is fragile and unpredictable. Global growth is slowing, and central banks are running out of road. Against this backdrop, investors need to stack the odds in their favour.
An investment in Japan does that. It is out of favour, cheap, close to a cyclical low and awash with unused cash. It is as good a place as any to ride out what might be a difficult fourth quarter. A cynical colleague once said to me ‘it’s never too late to short Japan.’ I think it now is.
The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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