May 24, 2013
|Campbell Gunn, portfolio manager of the T. Rowe Price Japan Fund (PRJPX)|
Although it is tempting to either take short-term profits or to dismiss this rally as yet another false dawn, the prospects for real change in Japan are better now than at any time in the last seven years. The task facing Abe's new government is daunting, but in the words of another transformational politician, "there is no alternative." The Japanese people now understand what is at stake and are no longer willing to accept the status quo—this will be an all-in effort. Japanese equities have already discounted the first phase of this "revolution," but based on historical precedents, the best may be yet to come.
A remarkable change of sentiment has begun to take hold in Japan, via the unlikely form of a "revolution" led by Shinzo Abe, an experienced politician from the Liberal Democratic Party. In December 2012, Abe swept into the office of prime minister for a second time with a convincing majority derived from the promise of widespread economic reform, now popularly known as Abenomics. While the continuous failure of previous governments has resulted in justified skepticism toward Abe's initial rhetoric, actual policy announcements have thus far been bold. Abe's strategy of "shock and exceed" has surprised the market and caused many investors to question whether Japan may finally be able to exit deflation.
Of course, such periods of hope and expectation are familiar to long-term Japanese investors. Having seen its market peak in 1989, Japan has subsequently experienced the longest period of economic malaise for any major economy in modern history. During the past two and a half decades, Japan has also had several false dawns. Understandably, caution persists among many investors given the experience of the past 25 years during which Japanese stocks have underperformed most major asset classes, delivering negative absolute returns along the way.
Despite some commentators' misgivings, our view is that the political intent and the scale of the changes underlying this recent burst of optimism constitute a different and potentially more durable catalyst. Rather than anticipating a cyclical upturn, stock prices have begun to reflect the impact of Abe's focus on changing long-term expectations surrounding corporate profitability and governance, domestic inflation, and personal wealth in order to reverse 25 years of embedded corporate and consumer behavior. Over this period, low growth expectations weighed on consumer spending and business investment, while the strong yen further hindered the country's export capacity. Add to this backdrop the demographic drag of an aging population and the related reduction in consumption willpower, and the magnitude of the challenge ahead is laid bare. While the scale of this task is clearly not one to be underestimated, the recognition of the need to implement policy on such a broad basis is a meaningful deviation from previous attempts to evoke change in Japan.
Despite our optimism over recent events, Abenomics is both an unfinished and untested revolution. It is therefore important to understand the schematic Abe and his officials have laid forth. At the heart of the government's plan is a lyrical "three arrow" approach of (1) looser monetary policy and inflation targeting; (2) expansionary fiscal policy; and (3) longer-term structural reform. While any individual arrow can be broken, Abe and his team argue that the three together are much stronger than the constituent parts.
Abenomics will target change by implementing policy in two phases. Phase I, which will be completed by July this year, is securing a majority in both houses of the National Diet in order to implement immediate and radical policy initiatives that have been absent in Japan for a decade. As part of the first phase, Abe has overseen the appointment of the like-minded Haruhiko Kuroda as governor of the Bank of Japan. Backed by strong deputy appointments to the Board of Governors, Mr. Kuroda has immediately implemented cohesive and dramatic policy change. Phase II will take shape after July 2013, when working majorities will allow larger and more complicated structural reform to be passed.
The sudden turnaround in the fortunes of the world's third-largest economy has gathered increasing attention from investors. Skeptics might argue that Japan is seeing another false dawn, as was the case in the middle of the last decade, but tangible signs of change are apparent. The Abe-led Liberal Democratic Party has successfully broken the recent tradition of policy inertia and has jump-started markets with the magnitude of its monetary policy program and its broader intentions. The early signs are promising. Profits are growing rapidly due to yen weakness, while gross domestic product estimates see growth of 2% to 3% during the next few quarters. Temporarily, at least, Japan has the characteristics of a growth market.
A growing wealth effect is taking shape within Japan following the recent market rally, evidence (albeit still nascent) of rising wage inflation and growing expectations for a recovery in the property market. These rising expectations, in addition to improved earnings expectations, and the low relative and absolute return outlook for Japanese Treasuries, are attracting investor flows into Japan's stock market. Should domestic asset prices continue to rise, we believe this early trend will gather momentum. Certainly, the potential exists for further interest in Japanese equities. Many foreign investors remain underweight in the Japanese market. Japanese pension funds held just 9.7% in domestic equities at the end of 2012, and Japan's younger population holds negligible amounts in equities, preferring to hold cash as their primary asset class. Further investor flows, as Japan's story evolves and becomes better understood, will only add fuel to the fire and produce further market gains. The weakening of the yen and the wealth effect from the Japanese equity market's gains have already improved sentiment in the corporate and consumer sectors. The index of consumer sentiment saw the largest jump in history in early 2013 and ongoing optimism from consumers and corporations is clearly part of the foundation for a healthy Japan. Abe is now the first prime minister since Mr. Koizumi in 2006 to see a rise in popularity in his first few months in office. Sustaining that momentum will be difficult, but, at least for now, we see meaningful scope for optimism.
Of course, investing in Japan continues to involve unique economic, corporate, and political factors—issues requiring a degree of comfort, but more importantly, a deep understanding from investors who have largely ignored this market in recent years. The magnitude of any future returns will be dependent not only on policy efficacy, but also external growth factors, especially in Europe and the U.S. While the recent rally in Japan is justified by what were excessively cheap valuations and subsequent earnings revisions, progress in addressing the economy's structural challenges is necessary before investors are likely to commit for the long term—all three of Abe's arrows must hit their marks. Failure or disappointment at any stage on the political front will likely catalyze a reversal of the yen and dull the recent strength of Japanese stocks.
These words of caution should not cloak our bullishness, however. Our expectations for meaningful change in Japan are higher than at any stage in the past decade, and if policy proves effective, we believe that Japanese stocks encompass material upside in the coming years. Valuations for Japanese equities remain attractive; the earnings potential of Japan is increasing; and, as improvement continues, we believe that foreign investors will once again return to Japan. Such a trend could provide further upside to rival previous market rallies. In short, profound changes are at work in Japan—and real change often brings real opportunity.
The following points reflect the views of Campbell Gunn, manager of the T. Rowe Price Japan Fund as of May 20, 2013
Because of its focus on a single country, the fund involves higher risk than a more geographically diverse international fund. Share prices are also subject to market risk as well as risks associated with unfavorable currency exchange rates and political or economic uncertainty abroad.