16 December 2022

Where are the black ships?

An article on Japanese equities is already of pretty niche interest, so why not go even more niche by starting off with Stephen Sondheim?

To begin, if I may, my lord I've no wish to remind you But you'll notice just behind you There are ships in the bay They've been sitting there all day With a letter to convey And they haven't gone away And there's every indication That they're planning to stay, my lord... 

“Chrysanthemum Tea” from “Pacific Overtures” 
by Stephen Sondheim 

Pacific Overtures is a story of the friendship between a samurai and a fisherman set against the background of Commodore Perry’s (no relation) Black Ships anchoring themselves in Edo Bay and demanding trade access to Japan and the ending of Japan’s policy of isolation.

Time has passed, attitudes change, and instead we find ourselves standing on the shores of Tokyo (née Edo) Bay wondering at the near complete absence of Black Ships. Foreign interest in Japan has ebbed away with the tide.

Going back a decade to 2012, just before Shinzo Abe returned as Prime Minister and the eponymous Abenomics, interest in Japan from foreign investors had similarly been at all-time lows – but with more reason. However, the ensuing decade has seen a steady increase in profitability, shareholder returns, and a revolution in corporate governance.

Over the last ten years the Japanese stock market has risen threefold, outperforming both the FTSE and European markets (albeit not in the last year or so). Despite that, the market never rerated upwards and despite that, the foreign investor has left. It’s not easy to get a complete picture of asset allocation to Japan but various analyses suggest that it is now even lower than it was in 2012.

A significant part of the problem over the last year has been the currency. The Yen has depreciated significantly year to date since it is the last major economy still maintaining a quantitative easing policy. This may look bizarre to Western observers but core inflation (ex-fresh food and energy) is still just 1.5%.

Japan’s monetary easing policies – known as Quantitative and Qualitative Easing (QQE) – that were introduced in 2013 by the Bank of Japan Governor Haruhiko Kuroda were designed to increase inflation. While the headline rate of CPI still looks low, this is somewhat misleading. Inflation has broadened out significantly. In the 30 years since the end of the Bubble, there has never been a period when so many different parts of the CPI basket are increasing as rapidly as there are now.

This is not just a statistical artefact. Companies are telling us that they can lift their prices in Japan and those price hikes are sticking.

This shift in behaviour potentially presages a sea change in the Japanese economy. A persistent feature of Japan has been the vast amount of cash on companies’ balance sheets. This is a result of the deflation that lasted from the Japanese banking crisis in the early 2000s through to QQE. The financial crisis and associated deflation caused a period of sharp deleveraging by corporations. That in turn exacerbated the deflation and in so doing increased the attraction of holding cash even more - the classic deflationary spiral.

The Yen has depreciated significantly year to date since it is the last major economy still maintaining a quantitative easing policy. 

This is what QQE was meant to unlock. It was never about saving the banking system like QE was in the West. It was about changing inflation expectations: as inflation lifted then the cash that companies were hoarding would stop offering a risk-free real return and instead become a wasting asset.

We believe that we are now at that pivot point. This implies that we are on the threshold of a strong investment cycle in Japan as those cash piles are used for capex or M&A or paid to shareholders. Thus the vicious cycle turns virtuous. A rerating should follow.

A further consequence is that we are heading to a turning point in monetary policy. Kuroda’s term of office ends in April. While Kishida has said little about who he might nominate for the next BoJ Governor, it is worth noting that he did place Hajime Takata, who has been consistently calling for an end to QQE, onto the BoJ’s Monetary Policy Board.

A change at the BoJ towards normalising monetary policy would cause a sharp strengthening of the Yen. Foreign investors who return would therefore benefit from a currency tailwind as well as the benefits of a new investment cycle. Could we once again see Black Ships in Tokyo Bay?

Pictet Asset Management Ltd Views and opinions expressed in this article are those of the author. The information does not constitute advice or a recommendation. Pictet Asset Management Ltd is authorised and regulated by the Financial Conduct Authority and registered at Moor House, 120 London Wall, London EC2Y 5ET. www.am.pictet 

Sam Perry
Senior Investment Manager at Pictet Asset Management Ltd

Illustration by Andrew Rees

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