Japanese equities were one of the stand-out performers on global share markets last year.
Japanese equities were one of the stand-out performers on global share markets last year. In what was a remarkable year for any Japan-observer, corporate visibility improved, the banking system was recaptalised, and most importantly, microeconomic reform gathered pace – bringing with it improved capital management, a spate of mergers and acquisitions, and increased demand by both locals and foreigners for equities.
However, this is not a one-year story. What we see in Japan is a multi-year phenomenon, something uncannily similar to Europe several years ago, and one which should deliver investors solid returns over the medium to long term.
Japan represents a unique investment opportunity, and has shown the ability to operate independently as a share market. For instance, when all other regions corrected during the latest bout of interest rate volatility in January, Japan broke the trend and stayed in positive territory.
Indeed, Japan today is a very different proposition to the Japan of the past decade. That is not to say the pain is over on all fronts. In fact, in this process of rapid change we are now seeing, it is abundantly clear that there will be just as many winners as losers. As a result, we will see some hiccups along the way, with short-term volatility likely to be higher in Japan than in other markets (with the exception of Asia). Nevertheless, we have entered a dynamic period, which is apparent if you look at the fundamentals.
The new Europe
Significant changes at the corporate level are the key driver of BT’s medium to long-term positive outlook for Japanese equities. Much of this change is due to the increased regard for capital return by some Japanese companies, a trend we also noticed in Europe several years back. As companies start to focus on the return they are getting on their capital, restructuring occurs, and, as witnessed in Europe, strong company performance usually follows.
While the restructuring comparisons to Europe are perhaps the most convincing argument for Japanese equities, it is true that the regulatory improvement in Japan has aided this process. This was also a feature of Europe’s multi-year recovery.
In Europe’s case, the emergence of one pan-European market saw regulatory standardisation, and allowed greater competitive forces to flourish. In Japan, the gradual removal of an archaic regulatory system has started to bring about greater visibility and greater competition. Looking back was hamstrung by a lifetime employment culture; a tax regime which saw companies under-report earnings and overspend; and an accounting system which meant that assets could be left off the balance sheet.
The rise of the shareholder
The unwinding of cross shareholdings also marks a major shift in the Japanese mindset and is good news for equity markets. Traditionally, the Japanese system has been stakeholder driven, rather than shareholder driven. This meant that shareholders were in fact minority holders, while mutually exclusive business groups – known as “keiretsus” — were the dominant drivers of company behaviour. It is important to note that at the centre of each stakeholder group was a bank.
Companies within a keiretsu would profit from the relationship via cheap funding, or via a beneficial client/supplier relationship. Meanwhile, shareholders were disadvantaged, because of the inherent inefficiencies of such a system.
However, cross-shareholding relationships are now unwinding as companies are forced to restructure their balance sheets, and seek business outside their group to remain competitive. The impact of this change is seen in the fact that foreign ownership of Japanese shares exceeded that of domestic banks for the first time ever in March 1999.
Consolidation
Merger and Acquisition activity has increased steadily since 1991, with the most dramatic rise being since 1996 — both on a domestic and international level.
While the removal of cross-shareholder ownership and certain regulatory controls have contributed to this trend, cultural change has been a major reason for increased M&A activity. In short, Japanese companies have been looking at a wider range of solutions to revitalise their business as they realise they need to change to be competitive.
Pension squeeze
The final trend which should support equity markets going forward is increasing domestic demand for growth assets.
Japan has an aging population, with the majority of savings directed towards risk-averse assets (about three quarters of household savings are tied up in some form of deposits). With the low rates of return being paid on these assets, the government has realised it would face a huge social security liability without pension reform, and hence has introduced a pension reform package proposal to parliament. The package is similar to 401K plans seen in the United States, and when introduced, should see a substantial increase in equity flows.
Dean Cashman is the head of Japanese equities at BT Funds Management
