What’s Driving Japanese Equities

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Text transcript

Murdo MacLean, client investment manager, Walter Scott.

When you look at returns from the Japanese market over the last couple of years, in 2019 MSCI Japan rose around 20% in U.S. dollar terms, which is a pretty good return. However, it does lag, or did lag, MSCI World, returning 28%. And then also MSCI U.S. [was] notably strong, just over 30% over the course of the calendar year 2019. So whilst it did return quite a nice level, it did lag global benchmarks.

Now, if you look at 2018, Japan actually suffered less well again in a different sort of environment. Where MSCI World fell around 9%, Japan fell 13%. Just taking some of these tax issues and the general economy of Japan, I think despite the second hike to VAT that happened in October here taking it to 10%, the fourth quarter returns to Japanese stocks was actually quite healthy — just over 7% in U.S. dollar terms. So pretty healthy return there despite some of the uncertainties that the tax hike might cause. And indeed there were some concerns that a move to tighten at this point in the cycle might be detrimental to the Japanese economy, particularly at a point where other central banks are adopting a more relaxed or loose approach to sort of fiscal policy.

Nonetheless, Japan, the reason why they moved to move tax up is that they face, as many of us know, the difficult task of trying to balance the fiscal structure. Net debt to GDP lying at around 150% — that is quite a sizable number. They are not alone in that in that respect, but they do need to obviously increase the tax take as well. That’s really what’s behind this move to do so. But at this stage it looks to have gone through fairly smoothly.

The Japanese economy, and by association its equity market, is highly sensitive to the global macro backdrop. It is one of the more sensitive, economically sensitive developed world indexes and indices as we see it. This really stems from its exposure to sectors such as autos and electronic components, and indeed the semiconductor supply chain. These are typically more cyclical than your average corporate, although over many years, and certainly in our view going forward, these typically are also still in the ascendancy and still home for some growth businesses.

So as long as we don’t see any evidence of a global recession, and whilst there is all the concern out there, despite in the inverted yield curve that we saw last year and the fact that that may, or has in the past, preceded a recession, there is really no concrete evidence of a global recession around the corner. And indeed, when you couple that with corporate Japan, how they’re talking around their businesses, generally things seem to be in pretty good shape. Which ought to bode well for the Japanese stocks and Japanese market going forward, certainly in the short to medium term.

Now, in addition to that, the recent Nissan issue with respect to the scandal that broke at the top of that company and Carlos Ghosn’s arrest, and obviously subsequently he’s fled the country, but that issue is a timely reminder that Japan is still dealing with a number of structural issues, particularly with respect to corporate governance standards. Now that said, under Prime Minister Abe’s tenure, the country’s leading companies are beginning to make changes that people have hoped would happen for a long time now. But at the same time, that’s still a very much a sort of in-process issue.

Now, whilst we know that it is indeed wealth created by corporates that drive share prices, these long awaited improvements to corporate governance structures and potentially more generous distributions to shareholders — through dividends and share repurchases — does offer investors other reasons to potentially consider Japanese stocks going forward.

Our long-held position, because we are, as many may know, we are a buy-and-hold investor, so our average holding periods are around about the 10-year mark. So given that we tend to invest and hold businesses for quite a long time, that also affords us the opportunity to engage with them on issues such as corporate governance and shareholder returns, which I previously mentioned. And I have to say, one of the most pleasing things, especially in the last few years, is the degree to which those corporates are beginning to listen. So we already have witnessed positive steps towards improved outcomes from the likes of FANUC, a company that we’ve invested in for almost 30 years, and from SEKISUI Chemical, another large Japanese holding fund, and again one that stretches back to the early 1990s in the Walter Scott portfolio in our client portfolios.

So that’s very pleasing to see that they are making tangible steps to improve the returns for shareholders. And our expectation would be that these companies continue to possess the qualities to contribute materially to client returns in the next year, three, five and beyond years.

From a sectors perspective, as I say, we look at companies rather than sectors, but we do have to admit that areas such as technology, obviously, industrials and healthcare are really the areas where we think Japan continues to possess some world-leading companies. That is why we tend to find the majority of ideas, and indeed many of the existing holdings, in those sectors. Those are the areas where Japan has a good history of innovation and innovation that drives growth to these businesses. Hence, they tend to be a happy hunting grounds when it comes to looking for companies there. Those sectors, indeed, also globally enjoy structural tail winds behind them, which obviously makes it much easier for those companies to benefit from growth in those sectors.