A look to the East, the Far East

Julian Chillingworth, CIO at Rathbone Unit Trust Management, on why investors should take another look at Japan.

Is it time to review Japan? Like many investors, we have been guilty of getting bored of it. Our economic view has always been pretty consensual – over the past 20 years, Japan represents a catalogue of economic mismanagement; a policy-laboratory of ‘how not to do it’.

The Japanese authorities look to have exhausted their monetary policy ammunition when it comes to weakening the Yen and inflating the economy, and whatever they have done so far has failed miserably. The West is looking on with worry and for clues on how to avoid a deflationary spiral.

A problematic demographic; a culture that lends itself to a high savings ratio; a belated address to its banking problems all continue to blight progress – it’s no wonder that aversion towards Japan has never been higher.  Something’s changing though, and perhaps history and the Japan of today are worth another glance.

On paper, the economic history of Japan since the 1990s looks dire; the dives in the stock market look even worse. However, as other commentators are now alluding, today’s Japan is still ticking over. It flies in the face of perceived wisdom about how economies ‘should’ perform in a deflationary environment. Perhaps that’s a topic for another debate, but what it might answer is how investors behave given that situation. Naturally, we turn to Japanese sovereign debt. Interestingly, foreign appetite for JGBs (Japanese Government Bonds) has not waned.

Following the Greek sovereign debt crisis, there was a feeling that Japan would be brought to task by the bond vigilantes, but it hasn’t materialised.  At this juncture, the ten-year JGB is yielding 0.98%. If you believe in the deflation story, then a positive real yield makes this a relatively attractive bet, although foreign buyers would likely lose money on hedging costs.

Pockets of Japanese equities are now looking attractive though.  While the rest of the world has been rebuilding its collective balance sheet, Japanese companies have also reduced costs by impressive amounts.  Corporates are operating at peak levels, with margins edging towards pre-crisis levels. Also, all is not bleak on the revenue-front either.

Despite remaining significantly down, revenues are shifting away from the domestic market. Japan, among other things, is essentially a long bet on the Chinese consumer and, arguably, tech stocks are in the initial throws of a bull phase, although some concern remains over the price attached to recent merger activity.

There is another potential fillip in the form of intervention by the Bank of Japan in curbing the strength of the Yen, which at this juncture, is looking quite extraordinary. Should it manage to convince the market of its efficacy this time, there could potentially be an attractive risk/reward trade-off. Some form of massive intervention looks inevitable.

The bottom line is there is more upside in government bonds, despite the ultra-low yield levels. That’s not to say it’s the most efficient place to be, but while deflation fears persist, for many investors, it offers a rational place to park cash.

On the face of it, the economy is screaming for aggressive intervention, although many lead indicators are now signalling economic strength coming through, albeit fractured.  For equities, the health of corporate Japan suggests the biggest risk may be to have no exposure at all. Worth a second look.