Japan is tricky. Its economic and financial fortunes have confounded most analysts since the bursting of the late 1980s asset-price bubble. All too often during the past 20 years, foreign investors have been on the wrong side of the trade when it comes to Japan.
Equity investors who thought the Nikkei was a bargain at 15,500 in 1992 – it was 60 per cent off its peak after all – must have thought it was unbelievably cheap at 7054.
Traditional valuation metrics often work but sometimes valuation is like beauty: it’s in the eye of the beholder. In mid-1997, there were very few takers among foreign investors for 10-year Japanese Government Bonds yielding ‘only’ 2.5 percent. They broke below 1 per cent in 1998 and bottomed out at 0.43 per cent in 2003. They currently yield an astounding 0.75 per cent.
More than just the economy
Understanding Japan requires understanding not just the economics but the demographic, political and cultural factors at play. The most powerful long-term thematic at work is demographic change. Japan’s population is in structural decline, meaning the labour force is shrinking and that long-term growth can only be driven by increases in productivity.
A political and cultural aversion to immigration – the antidote to defective demographics – is unhelpful if your goal is faster potential growth. In fact, during the past 20 years, Japan’s economy has only managed real annual growth of 0.8 per cent.
Another issue to consider in discussing Japan is credit and here things become somewhat paradoxical.
On one hand, Japan’s large globally focused corporations and its household sector have low levels of indebtedness. On the other hand, thousands of small to medium-size enterprises are heavily indebted and survive only on the good grace of their bankers.
These companies are, in effect, the rotten core within the Japanese economy and their mere existence saps productivity from the system. In addition, Japan’s government has the highest level of gross public debt in the world.
For years, economists have warned of the unsustainability of Japan’s budget deficits and public debt levels. Under certain scenarios Japan is vulnerable to a loss of confidence by bond investors. Nonetheless, Japan’s fiscal predicament has been discussed for more than a decade.
Currency and current account
The risks, while real, are probably pushed into the long-term ether by a combination of factors.
Japan’s debt is denominated in Yen, which the Bank of Japan can print (having your own currency is a luxury more than one European country would appreciate right now).
Perhaps more importantly, though, Japan is still the world’s largest international creditor, backed by still-high domestic savings (corporate and household).
The real issue here is the dynamic between Japan’s investment and trade account. Japan’s current account remains in surplus despite running a deficit in its goods and services trade.
For the meantime, Japan’s international investments earn enough income to offset that deficit. However, its current account surplus has narrowed significantly in recent years.
The policy principle
There is scope for hope. Recent policy action has been positive. Prime Minister Noda has won legislative support for a further increase in the consumption tax (from 5 per cent to 8 per cent then 10 per cent), and early signs of both consumption growth and inflation are emerging.
For the first time in quite a while, Japan has a Prime Minister prepared to address the country’s fiscal problems.
Japan’s leading companies are world-beaters and appear to be trading at attractive valuations. And even some of the world’s most cautious global investors have begun to see genuine value in Japan.
Ben McCaw is an investment analyst at MLC.
