In Japan, a little inflation could go quite a long way. After stepping down six years ago, Prime Minister Shinzo Abe returned in November with a platform promising to put an end to the deflationary cycles that have plagued Japan for decades.
Early results are favorable. Abe pressured Japan’s central bank to adopt a loose monetary policy with a 2% inflation target and is holding the bank to a level of accountability that Japan’s public servants are not accustomed to. A byproduct of that loose monetary policy is a weaker yen, which has fallen 20% to 30% against major currencies since Abe stepped in. In an economy as export-driven as Japan’s, that helps a lot.
If these trends continue it could be a game changer for both the Japanese economy and Japanese equity markets.
The weaker yen raises profits from exports and should boost stock prices. And when Japan’s equity market strengthens, its economy follows. We’ve seen this virtuous cycle play out before, when a stronger Japanese equity market drove the economy forward from the end of 2005 until the financial crisis in 2008.
There are other knock-on effects of fighting deflation that should benefit equities. The Japanese consumer has a higher proportion of savings in cash than is typical for other countries. Meanwhile, Japanese public pension funds have underinvested in equity, preferring government bonds during Japan’s long period of deflation. If we reach an inflection point where deflation stops and inflation takes hold, massive amounts of cash could flow into Japanese equity markets, further driving up stocks.
While there are plenty of benefits if Japan can finally see a constant, healthy level of inflation, there are still risks that could prevent it. Two stages of consumption taxes are set to take place in Japan over the next couple of years, raising that tax from 5% to 10%. The taxes are contingent on Japan experiencing economic growth, but could put the brakes on economic progress once they kick in.
There is also political risk. Abe was an ineffective prime minister several years ago, as his policies were blocked by Japan’s legislative body. He will get an early test of his ability to carry out his ambitions when he seeks approval for his nomination of a new governor for Japan’s central bank.
Early signs are positive though. Abe has seen his approval ratings rise since taking office. That hasn’t happened for a Japanese prime minister in a decade. Markets also have responded well, and Japan’s major stock index has risen 20% over the last few months.
We believe Japanese equities will trend higher if Abe is successful in maintaining inflation, but stock selection will matter in the coming months. Stocks for some of the most obvious beneficiaries of a weaker yen — namely large exporters with lower profit margins — already have been driven up. Large exporters with lower profit margins see the most operating leverage from a weaker yen.
Other less obvious opportunities remain. In our view, companies tied to Japan’s automation industry are particularly attractive. While these companies generate most sales through exports, their manufacturing costs are in yen. A weaker yen increases their profit margins. We think the market has overlooked these export-heavy companies because they already have high profit margins.
But the currency benefit for Japan’s automation companies is substantial. Our conversations with companies that are heavy users of automation equipment suggest that Japan already holds a superior technological edge to its biggest automation competitors, which are in Germany. But the yen’s devaluation against the euro over the last three months puts Japanese products at a distinct price advantage versus German equipment.
Japanese real estate development companies are also an exciting opportunity. With consistent inflation, we expect real estate properties to be bid up sharply. Real estate developers own large blocks of Japan’s most desirable properties. For example, Mitsubishi Estate owns 60% of the real estate in Tokyo’s central business district, which is also the nexus of the city’s train systems. When real estate prices rise, rents in this area tend to rise significantly.
The land of the rising sun has had false dawns before. But if Abe and his colleagues get it right this time, the 20-year Japanese slump may be over. Investors should pay attention.
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