The third largest economy in the world is facing unprecedented economic challenges, with consumer prices falling for the first time in three years and the fastest slump in factory production in over two decades. Japan’s longest serving Prime Minister Shinzo Abe has unveiled by far the largest and most comprehensive stimulus plan in modern Japanese history, conscious that this heavy economic toll has also stoked fears of a return of the old foe. Deflation.
Stepping back for a moment, Japan was the second country to report a confirmed coronavirus case outside China in mid-January. Similar to Singapore and Taiwan, it initially seemed to have a reasonable control on the spread of the disease. Despite continuing criticism surrounding low levels of testing, theories for Japan avoiding the devastating tolls witnessed in Europe and America range from greater obedience to government authorities, who acted swiftly in telling citizens to enforce naturally greater social distancing measures, to habitual mask wearing due to experiences of dealing with past influenzas. The bureaucratic legacy this left behind in the form of planning capacity for dealing with new epidemics, coupled with a healthcare infrastructure for an aged demographic has led, thus far, to a milder direct economic impact than many other countries.
However, Japan will be just as exposed, if not more so, to the indirect impact as the rest of the world shuts down. With a substantial manufacturing base and more than its fair share of automakers, industrial companies and electronic component makers, almost two-thirds of Topix profits are ultimately generated overseas. To stave off this impact and the threat of another ‘lost decade’ of deflation tarnishing his legacy, Abe’s response has echoed the US Federal government’s aggressive playbook by injecting a $1.1 trillion financial stimulus package into the economy, amounting to 20% of their annual GDP. Heightening calls for bigger spending in a bid to preserve corporations through the pandemic, the Bank of Japan’s governor Kuroda has fired another salvo, flooding yet more financial stimulus into the ailing economy with its ‘whatever it takes’ pledge to purchase unlimited government bonds.
Whilst the darkening economic outlook for Japan looks bleak and Abe and Kuroda continuing to experiment with their combustible financial chemistry sets to beat deflation, one positive element is the country’s geographical exposure. Japan has the enviable benefit of having the US and China as its two largest trading partners. While this means that it was exposed to the sharp slowdown in China, it also means that it is exposed to the recovery in China and the sizeable Chinese stimulus package. China has already moved to a post-pandemic position and economic activity is resuming, evidenced by improvement in the industrial activity of the economy and daily passenger data across road, rail and air showing signs of recovery. The US is likely, wisely or not, to reopen soon as individual states are already relaxing social distancing, reopening stores, services and firing up the global industrial engine room once again. If China is in any way a reasonable model for the rest of the world, then there is positive news ahead.
Japan also has two other positive elements to note. Firstly, most companies have large amounts of cash and small amounts of debt, making them somewhat resilient to the loss of revenue from the pandemic. Secondly, as a consequence, the likely dividend return from Japanese equities looks less threatened and more robust than other more leveraged developed economies. Unlike most other countries, the Japanese market has not re-rated up over the last decade. Even before the COVID collapse in markets, there had been no increase in multiples, or valuations, and as a result, Japan remains a cheap market with large amounts of cash.
It becomes clear that Japan is in a comparatively strong position and a far less perilous one than the deflation vultures perceive. Consumers and corporates continue to boast enviable cash coffers, and banks are well capitalised offering ample dry powder in times of market stress. Once the outbreak slows down, or the Holy Grail in the form of a vaccine is achieved, a large part of the lost output should be recovered. Notwithstanding the fact that a fund will be a suitable investment for an individual as circumstances and objectives are very different, one fund that I feel should benefit from this recovery in manufacturing and capital expenditure will be the Pictet Japanese Equity Selection Fund, a large to mid-cap Japanese equity portfolio managed by Sam Perry, which we recently added to our preferred fund list. The experienced Pictet team, predominately based in Tokyo, has deep understanding of the Japanese equity market through multiple business cycles and a robust screening process of Japanese companies and management. The fund has outperformed the Topix by over 5% since the start of the year and the focus is very much on companies with clear long-term growth drivers that also have the financial strength to withstand the current period of uncertainly and extremely low economic activity.
History has repeatedly proved that crises, shocks and pandemics can drive and accelerate the emergence of certain behaviours. In this context, more dynamic companies capable of flexibility and adaption tend to come to the fore providing valuable opportunities for companies in particular industries e.g. home working, cloud computing, online shopping and delivering, digital payment and communication. Baillie Gifford Japan, run by Matt Brett and Praveen Kumar, has exposure to a number of these companies optimising this ‘new environment’ and has recently seen its discount widen significantly. Most of the trust’s long-term performance record was generated under its previous manager, Sarah Whitley, who left at the end of April 2018, when Matt took over the helm.
However, Baillie Gifford funds are run very much via a team approach, with investment ideas generated from a number of sources, including other areas of the company. As a result, the trust’s investment process has not changed following Ms Whitley’s departure, as Matt, who joined Baillie Gifford in 2003, has worked alongside Sarah since 2008. The Trust has moved to a 9% discount having traded at an average premium of 2% over the past 5 years. It is one of the cheapest active Japan funds available and the widening discount could create opportunity for amplified returns over the long-term, again remembering that individual objectives and circumstances may mean this is not relevant.