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December 6, 2012

Campbell Gunn Campbell Gunn, portfolio manager of the T. Rowe Price Japan Fund (PRJPX), explains how core strengths may help the country overcome significant challenges.

The earthquake and tsunami that devastated Japan on March 11, 2011—known in the country as 3/11—came after a long period of economic stagnation leading to a 27-year low for the Nikkei 225 Index in 2009. A year later, China surpassed the country to become the world's second-largest economy. Today, Japan faces a rapidly aging population, a tight job market, and deflation. Despite its challenges, the country remains one of the world's most important economic engines.

Japan is home to some of the world's largest and strongest companies—including consumer electronics and auto manufacturers—and it ranks among the most technologically advanced nations on the globe. Japan is also notable for its resiliency: Within weeks of the earthquake and tsunami, the Nikkei index had more than regained its losses. In March 2012, just a year after the catastrophe, it closed its best quarter since 1988. The country today—with a slightly weaker yen and attractive stock valuations—may offer growth potential for equity investors.

The Japanese Economy

Japan's difficulties began long before the disasters of 2011. The country experienced a real estate bubble that burst in 1989. Subsequent years of deflation and a very strong yen made exports less competitive on world markets. "If you go back 20 years, Japan had one of the biggest bubbles in history, driven by excessive credit growth," explains Campbell Gunn, portfolio manager of the T. Rowe Price Japan Fund (PRJPX). "The Japanese government and the Bank of Japan tried all of the economics textbook measures to get out of it, but in the end, the government had to borrow and spend."

Japan reduced its labor costs to remain competitive, a move Japanese workers generally accepted. The boom in neighboring China dramatically increased demand for industrial equipment, cars, and consumer electronics parts from Japan, boosting exports. Then came 3/11. Nationwide disruptions of nuclear power and the electricity it generated created a global supply shock due to delayed production of Japanese-made goods, including LCD screens, auto parts, and cast aluminum cases for lightweight laptop computers.

Japanese consumers responded to these events by tightening their belts. After 3/11, this nation of savers reached a new level of jishuku—self-restraint—by reducing household spending by 8.5%, further hampering an economy struggling to grow. And, unlike other nations in financial straits, Japan didn't borrow from the rest of the world to finance reconstruction—its debt was almost entirely domestic. As a result, the yen remained elevated relative to the dollar and other world currencies, making Japanese exports expensive for global consumers.

For years, the Bank of Japan, the country's central banker, accepted the strong yen. Its Board changed its posture beginning in February, when it implemented policies to encourage the yen to weaken in an effort to support exports and to pursue a goal of 1% inflation—a currency move Gunn judges to have been "thoughtful and well orchestrated."

The Long Term

In addition to the short- and intermediate-term challenges posed by the natural disasters of 2011, Japan is daunted by long-term challenges. The island nation is resource poor and heavily dependent on fuel imports. It is a manufacturing giant, but a rapidly aging population and a low birth rate are likely to undercut the stability of its workforce.

Japan's public debt currently represents nearly 220% of GDP.1 In comparison, the public debt of the United States represents 100% of GDP.2

One factor holding back the country is the need to support its aging population. Social Security is the government's largest obligation, in part because the Japanese have the longest life spans in the world. "There's no way to get around the demographic challenge," Gunn says. Certain solutions may help, to a degree: Japanese workers could retire later, the country could use more female labor (it currently has one of the lowest rates of women in the workforce in the industrialized world), or new policies may be able to encourage greater innovation and productivity. Unlike America, however, the country isn't likely to fill the growing labor void through immigration. "Language and cultural issues are major barriers to solving labor issues with immigration," Gunn adds. "Over the next 50 years, we'll see how gracefully Japan's economy ages."

According to the World Health Organization, about 22% of Japan's population was over age 65 in 2009—a figure projected to increase to nearly 40% by 2050.

But an aging population bodes well for Japan's existing medical technology firms. The country's pharmaceutical companies, medical machinery manufacturers, and other health care-related firms should benefit from growing domestic markets as the population ages. These firms also can take advantage of burgeoning health care markets in China and Russia, both of which are upgrading their hospital facilities.

Japan's service sector remains a trouble spot. The country focuses on construction and agriculture, says Gunn, while virtually ignoring tourism—an industry he says Japan could stand to grow. To achieve a more balanced economy, Japan would need to overhaul its industrial model while encouraging workers to think differently about their roles. Gunn, a longtime resident of Tokyo, argues that only a significant need to change will prompt the Japanese people to adapt. "It will take a radical shift, with a crisis as its catalyst," he says. "Japan today is a very comfortable place to work. Unemployment is low for young people. It's a fairly enlightened place to live. But significant change is necessary for the economy to be competitive, and change is uncomfortable."

The Role of Politics

Japanese citizens exhibited a notable spirit of national cooperation, sacrifice, and determination to rebuild following 3/11. But political gridlock among Japan's three major parties has hampered reconstruction efforts and contributed to consumer uncertainty. Gunn believes government spending earmarked for rebuilding hasn't yet trickled down to the most devastated areas. Bureaucratic red tape is still evident in one locality near the tsunami-devastated city of Sendai, for example, where Japan's inflexible government prevented a supermarket from opening because of its rules to protect small shopkeepers.

Japanese voters think so little of their nation's three political parties that, Gunn says, "none of the above" is the most popular choice in recent opinion polls. In fact, the major parties are polling lower than the established political parties in debt-ridden Greece. A populist movement spearheaded by 43-year-old Osaka Mayor Toru Hashimoto is gaining ground, however, presenting an alternative that could shake up the entrenched order and drive change.

Energy is among the most pressing issues the parties will face in next year's elections. Government policies will have a critical influence on Japan's success, or lack thereof, at addressing a severe energy dilemma. The failure of the Fukushima plant led to the closing of all but two of Japan's 54 nuclear power plants, which generated nearly 30% of the country's electricity. "The fact is that the plants are not safe. And they can't retrofit them overnight," Gunn says. "Japan once had the goal of creating 50% of its energy from nuclear power; now it's likely that will go to zero. That is a major problem for the whole economy."

How Japan will replace nuclear power remains an open question. Renewables won't make up the difference anytime soon. There isn't enough space for wind or solar farms, and Japan's geothermal stores can't create nearly enough power to make a meaningful difference, Gunn says. Nuclear power has been an affordable alternative to importing expensive liquefied natural gas, or LNG. (Japan pays the world's highest price for LNG.) Japanese firms are currently financing LNG exploration and development projects in Australia and British Columbia, among other locations. To date, Japanese companies, not individuals, have paid the price for the country's rising energy bill.

Competing in the Global Economy

Despite Japan's prominence in world trade, the country's economy operates in ways that are culturally distinct from other major players in the global economy, particularly in the West. Historically, the management approach of most Japanese companies emphasized employment stability and seniority. They offered fixed dividends, and their stock prices didn't fluctuate much. Moreover, they tended to operate more for the benefit of the management than for shareholders, Gunn says, and shareholders had relatively little say in decisions that affected their investments. "That's improving, and better companies tend to attract better investors," he says. "There are some young, aggressive entrepreneurs here. But there just aren't enough of them."

Yet worldly Japanese companies are taking cues from successful multinational firms. Some technology conglomerates are restructuring to make their models more competitive on a global scale. Others, such as lean automakers, are poised to take advantage of opportunities in emerging markets. Skillfully managed firms that sell good products have performed well despite significant headwinds, Gunn says.

Opportunities for Investors

Japan's manufacturing strength—which may increase if the currency depreciates—and relatively attractive valuations may make it an appealing place to invest for patient investors with a long view. Gunn seeks out companies that can grow sustainably and have above-average returns, typically because they demonstrate a long history of innovation or a technology no other firm can match.

The number of Japanese industries represented in that category is smaller today than in the past. But the firms that remain have become more specialized in order to compete with companies that have lower labor costs and better access to reasonably priced raw materials in other parts of the world. "Japan excels at certain technologies in which they still hold a comfortable advantage," Gunn says, speaking of firms that make medical equipment and precise electronics parts. "Japan still does that very well."

Japan's manufacturing strength—which may increase if the currency depreciates—and relatively attractive valuations may make it an appealing place to invest for patient investors with a long view.

When making investment decisions, Gunn values quality management and signs of efficient restructuring. He also looks closely at valuation. "Valuations are reasonably attractive right now because many investors either have given up or aren't captivated," Gunn says. "Interest in Japan among the foreign investment community is probably the lowest I've seen in my 30-year career."

That fact can sometimes indicate opportunity. For contrarian investors, it's a clear sign that Japanese equities may be worth a closer look. A shift in one of several factors—particularly a weaker yen or political change—could signal that transition is afoot, explains Gunn: "The tendency of this market is to move very far, very fast when the macro events change in its favor," he says. When it does, investors with a stake in Japanese firms may be poised to benefit.

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.

1International Monetary Fund, Survey Online, July 2011.
2International Monetary Fund, The State of Public Finances: A Cross-Country Fiscal Monitor, 2009.
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