Seven reasons why Japan equities haven't met expectations
For a few months toward the end of 2020, it looked as if Japanese equities were poised to stage a comeback after years of relative underperformance. The asset class drew investor attention after legendary financier Warren Buffet invested US$6 billion in the market,¹ which prompted many market commentators to speculate about the possible dawn of a new era.² Nearly one year on, however, it’s clear that things didn’t quite play out that way.
In fairness, the expectation for Japanese equities to outperform isn’t without merit—given the stock market’s value/pro-cyclical tilt (the composition of Japan’s TOPIX market is roughly 60% value stocks and 40% growth stocks),³ Japan should theoretically benefit from the rotation to reflation/cyclical trades in a post-COVID-19 environment. In addition, Japanese equities were also widely perceived as being inexpensive and underowned by foreign investors. These factors should’ve been a recipe for outperformance; however, the asset class continues to underperform its global peers. From a macroeconomic perspective, we believe there are several reasons why Japanese equities have underperformed relative to expectation.
Japanese equities have underperformed their global peers since Q3 2020
1 Monetary policy is relatively tighter
Although the Bank of Japan (BoJ) is perceived as being stuck in perennial easing mode (the central bank is the biggest owner of Japanese stocks thanks to its exchange-traded fund (ETF) purchasing program⁴), the reality has been quite the opposite. Net additions to the BoJ’s balance sheet have slowed sharply since Q3 2020. The BoJ has also changed the composition of its asset purchases, reducing its holdings of Japan’s government bonds and equity ETFs while piling into short duration bank loans through its Loan Support Program.
Net additions to BoJ's balance sheet
This doesn’t look like quantitative easing
2 Fiscal policy is relatively tighter
Japan’s government has rolled out robust stimulus packages to help accelerate economic recovery worth 5.3% of the country’s GDP. Crucially, its fiscal package went beyond crisis management and included measures such as direct spending aimed at promoting digitalization, boosting software capability, reducing carbon emissions, and enhancing the country’s competitiveness.⁵ On a relative basis, however, the United States and the eurozone’s approach to fiscal spending was much looser. Crucially, Japan is forecast to enter a fiscal consolidation phase by running tighter fiscal policy from as soon as 2022⁶ which, in our view, risks short-circuiting the domestic recovery before it’s secured.
3 Japanese corporates’ free cash flow buffer has been run down
Japanese corporates ran a strong positive cash buffer in the post-global financial crisis period; however, the pandemic led to a sharp decline in corporate profits and has subsequently eroded their cash buffer, which has all but disappeared.⁷
COVID-19 has eroded profits and free cash flow in Japan
4 Japan’s corporate profits haven’t been as strong relative to the United States
Broadly speaking, we believe that the underperformance of broad Japanese equities, especially versus U.S. equities, can be explained by examining the level of corporate profits in both markets in local currency terms. After outpacing their U.S. counterparts on the earnings front for roughly four years, corporate profits in Japan became increasingly negative from Q2 2020.⁸
Corporate earnings: U.S. vs. Japan, in local currency terms
5 Limited room for sustained JPY depreciation
From a foreign exchange policy perspective, Japan has leaned toward currency depreciation since 2012, arguably to protect corporate profitability. However, with the Japanese yen (JPY) being undervalued by ~20% (relative to purchasing power parity), the room for sustained JPY depreciation appears limited. And as we’ve outlined in the latest edition of Global Macro Outlook, our peak macro thesis suggests the risks are tilted toward safe-haven JPY buying as we encounter pockets of market volatility and increased uncertainty, which would translate into increasing headwinds for corporate profits in Japan.
6 Rising political risk
As we mentioned in our Q3 2021 Global Macro Outlook, Japanese Prime Minister Yoshihide Suga and his cabinet’s approval rating have fallen to a record low⁹ ahead of the general election, which is due to take place by October. Factors that have weighed against popular opinion include the administration’s handling of the COVID-19 pandemic and its decision to go ahead with hosting the Summer Olympics this year. While the governing Liberal Democratic Party has a clear lead in the polls, which has been holding steady at around the mid-30% range,⁹ a leadership contest is set to take place in September—there’s a nonnegligible risk of a rival candidate coming to the fore who doesn’t subscribe to Prime Minister Suga’s reflationary policies.
Public support for the governing party has slumped to record lows (%)
Source: NHK, Macrobond, Manulife Investment Management, as of July 13, 2021. The gray area represents the period when public approval rating of the cabinet began falling.
7 Disaggregated performance of Japanese equities has been consistent with expectations
As a final point, we’d note that even though the recent underperformance of broad Japanese equities versus international equities may seem unusual relative to historical norms (Japanese stocks, broadly speaking, have historically outperformed their peers during global expansion cycles), a closer examination shows that Japan’s value/cyclical sectors have outperformed their growth/defensive sectors. Notably, the cyclical rotation into value has in fact been strongest in Japan.³ In our opinion, this provides further evidence that it pays to be much more selective when it comes to investing in Japan, and we continue to emphasise relative value as a theme in asset allocation.
1 “Warren Buffett takes $6bn bet on Japanese trading houses,” Financial Times, August 31, 2020. 2 “Is Japan the land of rising returns?” This Is Money, October 6, 2020; “Japanese stocks catch global investors’ eyes as post-COVID growth play,” Reuters, November 11, 2020. 3 Bloomberg, as of June 2021. 4 “BOJ Becomes Biggest Japan Stock Owner With $434 Billion Hoard,” Bloomberg, December 6, 2020. 5 “Japan announces new COVID-19 stimulus for economy,” BBC News, December 8, 2020. 6 “Fiscal Monitor: A Fair Shot,” International Monetary Fund, April 2021. 7 Cabinet Office (Government of Japan), Bank of Japan, Macrobond, as of July 8, 2021. 8 Cabinet Office (Government of Japan), Bank of Japan, Japan Ministry of Finance, Macrobond, as of July 8, 2021. 9 “NHK Survey: Support for Suga at lowest ever,” NHK World, July 12, 2021.
Important disclosures
A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.
Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.
The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.
This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.
Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.
Manulife Investment Management
Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.
This material has not been reviewed by, is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional
Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad 200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltd. which is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.
Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
539864
