I travel to Japan every year, normally around early December. The more time I spend there, the more I come to realize what a uniquely distinct country it is. On my trip last week, one of my Japanese colleagues pointed out that Tokyo was starting to allow taller office buildings. I assumed the previous limitation was a function of Japan’s location in a geologically active part of the Pacific. My friend politely laughed. The injunction was due to the fact that no building was supposed to look down on the Imperial Palace.
Whereas city ordinances kept Japanese office buildings relatively shorter, up until recently economic stagnation, deflation and sclerosis had kept Japanese stocks from soaring.
Lots of construction for a country in recession
This has obviously changed in recent years. Japanese stocks have been among the best global performers over the past couple of years. I have been positive on this market for some time now, and despite a shaky start to the year and the current recessionary environment, I maintain that view. I would highlight three arguments:
Value. Japanese stocks remain some of the cheapest in the developed world. While Japanese equities rallied sharply in 2013, unlike the United States the gains came from earnings growth rather than multiple expansion. This has left Japan’s stock market a relative bargain in a world where few asset classes are cheap.
Multiple Catalysts. Undervaluation without a catalyst may just be a value trap, but there are several potential catalysts for further gains in Japanese equities: ultra-loose monetary policy, which should continue in 2015, aggressive buying of domestic shares by Japanese pension funds, and rising profitability thanks to share buybacks.
Reforms. Although I would agree that Prime Minister Shinzo Abe has under-delivered on the so-called ‘Third Arrow’ of structural reforms, there have been a few, notable accomplishments. Corporate governance has improved with more outside directors, and female workforce participation is on the rise. Another potential positive development: A Republican Senate makes the Trans-Pacific Partnership, a regional free-trade agreement, marginally more likely to pass. Should it pass, this would be a major victory for Japanese consumers and the economy.
If reforms pick up, will the Japanese Consumer buy more lattes?
One final point. One of the risks to my view on Japan is that the early election on December 14 could produce a nasty surprise for Prime Minister Abe and the ruling Liberal Democratic Party (LDP) coalition. While market participants see the LDP losing a few seats in the lower house of the Parliament, they are not expecting the ruling party to give away its majority, something that could be a risk factor.
LDP vs. DPJ, which will emerge as the victor?
But on the contrary, based on my conversations with Japanese investors and a recent article in a local newspaper, a seemingly lack of viable candidates from the rival Democratic Party of Japan (DPJ) suggests that the LDP may actually increase its majority. To the extent that a bigger majority emerges and the prime minister uses the mandate to push forward more aggressively on structural reforms, I believe Japanese stocks may continue to rise.