Strong, stable political leadership is crucially important for Japan to exit its deflationary spiral and carry out meaningful structural reform. There are, however, other factors to consider.
Abenomics, as the policies of Prime Minister Shinzo Abe are known, certainly provided the final push that was required to end deflation, but it was given a helping hand by the efforts of Japanese companies that had been taking measures to combat deflation long before Abe took office.
Prior to its successful deleveraging, corporate Japan had excessive debt and weak balance sheets that were a bottleneck for aggressive investment. The days of excessive debt are now gone, and cash generation capabilities have dramatically improved. Free cash flow is at a historical high, and corporations have more than $2 trillion to invest.
Notwithstanding Japan’s traditionally inflexible labor market, companies have reduced costs, lowering break-even points to levels not seen since 1990. The biggest drivers are the small to midsize nonmanufacturers such as retailers and construction companies, which have a big presence in a tightening Japanese labor market and pay about 60 percent of the nation’s wages. These companies are the biggest drivers that are helping wage deflation come to an end.
My analysts and I find evidence of this whenever we meet with the management of retail companies. These executives are constantly complaining about the difficulty in hiring salespeople at current pay levels. Recently, wages have been slowly rising across the country for the first time in 20 years; temporary construction workers, for example, are now receiving pay increases.
Of the so-called three arrows of Abenomics, the first two arrows — expansive fiscal policy and bold monetary policy — have been fully fired and are having an impact on the economy and on financial markets, as demonstrated by the 52 percent surge in Tokyo’s TOPIX index in 2013. Most investors enjoyed the Abenomics rally; that was the beta game. But I believe that the beta play is already over. What we have been waiting for is the third and final arrow of Abenomics: a private sector, investment-inducing growth strategy leading to a “Japan Is Back” status.
In June a “Japan Revitalization Strategy” was announced by a government council for industrial competitiveness, chaired by Abe. It emphasized four key policy measures: restoring Japan’s earning power; cultivating human resources (furthering women’s economic activity and utilizing foreign human resources); nurturing industries to become new growth engines; and regional revitalization and innovation of small and medium-size enterprises.
The implementation of these structural reforms will take time, but the required political leadership is there for the first time in ten years. The stiffening of the labor market along with deregulation of the financial market is expected to develop further in the second half of this year.
The stock market should begin to reflect these changes. The stock market declined modestly after the big gains of 2013, with the TOPIX shedding 3.1 percent, but overall company performance exceeded expectations, and the aftereffects of the consumption tax increase were not as bad as many had feared. Mergers and acquisitions activity is accelerating cost reduction. Restructuring and consolidation mean that the Japanese export sector is now more streamlined to compete globally again. Companies have learned lessons from their M&A failures in the late ’90s. They have been disposing of noncore assets and shifting to local production in order to accommodate extreme volatility in the yen. Companies now have the operational/financial strength to maintain prices even at the extremely high JPY levels seen before Abenomics.
Following corporate Japan’s cost reductions, return on equity is likely to reach 10 percent on average in 2015, and we forecast that about 30 percent of all public companies will post historically high earnings.
The change in corporate management is accelerating too. In particular, shareholder returns in the form of dividends and stock buybacks are gathering pace. This shows confidence by management regarding the future along with changing attitudes toward return on equity, a metric on which Japan Inc. had previously compared unfavorably with international peers. With the setting up of the Stewardship Code, which calls on shareholders to engage more actively with company management and disclose how they vote on proxy issues, and the establishment of a new, ROE-based index, the JPX400, corporate management attitudes toward shareholder return are slowly moving closer to those of their international peers.
In the medium term, investors in Japan will need to closely monitor the potentially sensitive foreign affairs within Asia. The relationship between the U.S. and China has many implications for Japan and for all of Asia.
China is facing deep-seated structural problems, such as investment-driven growth and an expanding shadow banking system. It seems that it will take time to resolve these issues, and there may be no short-term solution. Although the importance of China as a manufacturing base is decreasing for Japanese companies, the country remains a crucial market because of its geographical location and position as a close cultural relative. In principle, investors welcome China’s structural shift toward consumer-driven economic growth. However, we are concerned that this shift is taking place too fast and could have a negative impact on Japanese companies.
Although top-down monetary and fiscal policy played a leading role in the Japanese stock market in 2013, the focus on business-to-business disparity means that stock selection will be a key theme in 2014. The “Made in Japan” brand will continue to appeal to an emerging Asian middle class, and we will see the revival of streamlined domestic companies that took measures to combat deflation. Japanese brands will not sweep the Asian region as they did the world market in previous decades, but businesses that provide goods related to daily necessities, services and infrastructure will have good opportunities for growth.
The Japanese economy has suffered a nearly 25-year downtrend, from the collapse of the bubble economy in the early ’90s to the subsequent deflationary period. This should finally be the year that Japan not only escapes from its long slump but also finally commences on a meaningful upward trend.
Hiroyasu Sato is a senior fund manager at Tokio Marine Asset Management Co. in Tokyo.
