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Japanese Equities:
Trading Rally or Lasting Change?

November 9, 2015  | by Mark Bennett

Equities | Market Commentary

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Financial Crises in early 2009, but more recently, another major economy has taken over the leadership of equity returns.

Since the election of Prime Minister Abe to a second term in December, 2012, Japanese equities, in local currency terms, have far outpaced US, European and Emerging Markets, as the chart below depicts. During this period of time, MSCI Japan has gained 24.7 percent annualized in Japanese yen terms, outperforming the next best performing market, the S&P 500 Index, by 11.04 percent. What is behind this leadership change and how sustainable is it?

 

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Japanese equities have suffered from a very volatile trading history that dates back decades. Once the darlings of the economic and investment world during the 1980’s, Japan’s bull market crashed amid a massive real estate bubble in 1989. Since that time, deflation has gripped the economy, and stocks have found lower lows, with frequent and volatile trading oriented rallies.

All of this seems to have been reversed with “Abenomics”, a three-pronged approach of fiscal stimulus, monetary easing and structural reforms. On the structural reform side, recently enacted Corporate Governance and Stewardship Codes’ are bringing previously ignored shareholder friendly topics to the forefront of corporate Japan. Long criticized for not running corporations as return maximizing entities, the stated purpose of the new Japanese Code is to stimulate growth-oriented governance with an emphasis on improving profitability and capital efficiency. Combined with the creation of a new “JPY-Nikkei 400 Index”, ROE’s (Return on Equity) are on the rise, through a combination of increasing share buybacks and rapidly improving payout ratios.

 

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The JPY-Nikkei 400 Index was launched in January 2014 and was created to entice corporate Japan to boost equity returns. The index will only include companies that score favorably on ROE, operating profits and market cap metrics, with additional weight given to their willingness to elect independent outside directors, adoption of IFRS (international accounting standards), among other criteria. With the massive GPIF (Japan’s largest pension scheme) throwing their weight behind the index by using it as their benchmark instead of TOPIX, there is a virtual race to the top in corporate Japan to improve profitability.

Equally important is the Stewardship Code. This requires shareholders of Japanese equities to be “en-gaged” shareholders. ISS, the leading proxy voting agent, has recommended that investors use ROE as a measurement tool for the effectiveness of management, setting a 5% threshold. With cross-shareholdings a culturally prevalent tactic for doing business in Japan, previously dormant investors will now be required to “speak up” and become engaged as shareholders. Companies are encouraged to increase the number of independent directors on their boards, and cross shareholdings will now have to be disclosed, along with explanations as to why they exist.

So, will this environment persist, and will Japanese equities continue to outperform? Japanese equities have long been associated with an economy mired in deflation, worsening demographics and poor corporate governance. Because of this, active equity managers for many years shunned Japan, a decision that worked during the long period the Japanese market lagged the rest of the world.

Unlike previous trading rallies, the recent market strength in Japan has been accompanied by real structural change – improving shareholder returns, governance reforms and perhaps a hint of long absent inflation. Investment managers will need to take notice, and could create an environment of strong foreign in-flows at a time when domestic investors (GPIF) have begun to increase their weight to equities.

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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.