We once described Japan as the Buzz Lightyear market “to infinity and beyond”. Clearly that was an exaggeration to emphasize the impact of Abenomics back to 2012 however beyond aggressive policy easing Japan did embark on structural reforms in corporate governance which have contributed to a genuine improvement in trend returns on equity over the past decade. Japan’s return on equity has improved from around 6% to just under 10% (chart 1). While that that remains below the MSCI AC World, the gap can mostly be explained by sector composition or the contribution of US mega-cap technology companies. Put another way, Japan has similar ROE to Germany which has a similar market sector composition.
As noted recently by Gerard Minack, what drives equity returns is the ability of companies to generate a return through the cycle. Japanese companies historically had very poor returns on equity at the index level. Prior to the mid-1990s corporate investment in Japan was high relative to sales, while profit margins were low. The reverse is true today. Capital spending is low, and margins are high. Japanese companies (in aggregate) also have net cash on balance sheet.
While low balance sheet leverage is a positive attribute in a higher cost of capital environment, it might also reflect risk aversion or an absence of perceived growth opportunities. Nonetheless, there has been a genuine trend improvement in trend returns to shareholders. It is also interesting to note that the trend is opposite in China (chart 2). As Gerard observed, this is because earnings in China have experienced greater dilution. This is also a key reason why high economic growth does not necessarily translate into earnings per share growth or returns to shareholders.
An additional point we have often made about Japan is that the market has very high operational leverage. Put another way, Japanese equities have the highest sensitivity of EPS to global industrial production of any major market apart from Korea. That sensitivity is a probable explanation for the relationship between yen weakness and strength in the equity market. Trend weakness in the Japanese yen has been warranted by the terms of trade shock after the pandemic and the widening in rate differentials with the rest of the world. While the Yen is around 30% undervalued on a real effective basis (the trade-weighted exchange rate adjusted for inflation) interest rate carry is extremely negative relative to the dollar.
Although orderly currency weakness is positive for many Japanese exporters, we do fear the implication of a disorderly depreciation of the yen. Or as Dave Dredge of Convex Strategies has often asked policymakers about extreme measures (ZIRP,QE, YCC etc) “what if it works”? Could Japan maintain their stable disequilibrium of yield curve control if the US dollar rallied to 160 or 200 to the Japanese yen (chart 3). Based on the historic relationship with inflation and financial conditions, it suggests that the interest rate peg could get challenged at that point.
The troublesome aspect of a major dislocation in the yen is that it has often preceded episodes of cross asset volatility. For example, May 1997 USDJPY drops almost 15 big figures in two weeks and a couple of months later the Asian crisis erupts, June 2007 two Bear Sterns credit funds implode ahead of the 2008 crisis or more recently in mid-2015 China devalues the CNY, and a major phase of market volatility erupts with the global growth scare in early 2016. The Japanese yen has often been the tip of the market iceberg. A key reason for this is that the country still holds a large amount of net foreign assets which tend to be repatriated in times of crisis. As we noted above, while an orderly depreciation of the yen might be bullish for Japanese equities, an episodic collapse in the currency could be catastrophic and lead to a major repatriation of Japan’s net foreign assets.