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Japan is often described as a place where change happens very slowly. However, I’ve always thought of this as a somewhat misleading characterisation. While it may take time for change to manifest, once that change begins, things move quickly. The rapid change currently underway in the Japanese investment landscape is a case in point.
Deflation has led to significant unwelcome consequences for Japan over the best part of the last three decades, with no real wage growth for 25 years and no net investment growth for 15 years, with the knock-on effect being the accumulation of capital — the most primary force in modern capitalism — grinding to a halt. However, there are now multiple indications that Japan’s economy is beginning to awaken from the deep freeze that it’s been stuck in for the past quarter of a century, and breaking the mindset that everything gets cheaper every year has potentially huge ramifications.
Here, following on from my recent podcast, I assess the significant changes underway in Japan’s economy and labour market and consider the implications for Japanese small- and mid-cap equities.
Despite rising inflation (the Tokyo Core Consumer Price Index excluding fresh food and energy hit 3.4% in March, its highest rate since 1989), Japanese households are continuing to spend. Nominal retail sales rose 1.4% month on month in February, compared to an expected 0.3%. And for the first time in at least 25 years, annualised Japanese retail sales expanded faster than in the US.
In the past, when inflation has risen (largely due to VAT hikes), Japanese consumers suspended buying in anticipation that prices would come down. However, that’s not happening now, which may be a response to higher wages but could also signal that households are starting to believe that higher inflation will persist. The combination of higher wages, higher inflation expectations and evidence of margin protection raises the probability that higher inflation can be sustained.
With Japan on the cusp of finally exiting deflation, wages are rising amid extreme labour shortages. According to preliminary figures from trade confederation Rengo, workers’ average wages at the 805 unions surveyed will rise by 3.8% in the coming fiscal year, the highest jump since 1992 and well above consensus expectations. Subsequent wage deals may bring this average down as many smaller companies yet to report are likely to be less generous than their larger counterparts captured in the mid-March figure, but the wheels are now in motion in terms of setting the stage for a more consistent wage growth narrative going forward.
One of the most interesting pieces of the real-wage growth story is the generational shift — the steady breakdown in the lifetime employment system in Japan. This is leading to increased labour mobility as people start to change jobs more frequently in search of higher compensation and more flexibility. In addition to the severe labour shortages, this mobility helps to explain why Japan is experiencing the highest wage hikes in three decades — competition for quality labour is now intensifying, and companies are having to respond.
It's not yet clear how these latest wage figures will impact monetary policy. In December, the Bank of Japan (BOJ) unexpectedly lifted its long-standing yield curve control (YCC) policy to allow 10-year government bond yields to rise to 50 basis points (bps), from a target of 25 bps. While global economic uncertainty may delay further relaxation or a full exit from the YCC regime, work by our macro strategists suggests that current labour and wage dynamics could eventually force the central bank’s hand.
In my view, the end of deflation will weed out the so-called “zombie” companies that lenders have propped up in recent years. The government supported many of these companies during the COVID pandemic, but they will struggle to survive in an environment of rising labour costs and raw material prices.
Notably, we’re also seeing a continued shift in corporate governance, with a drive to allocate capital more efficiently and reward shareholders appropriately. Private equity has finally made its way to Japan, and is now making big inroads, primarily into large-sized companies, but the next step will be into the small- and mid-cap segment of the market, where mispricings are more extreme. A plethora of M&A brokerage companies have appeared in recent years to take advantage of the consolidation taking place in this segment of the economy.
Given these inefficiencies, there is no shortage of exciting opportunities in Japan’s small- and mid-cap space. There are more companies in Japan than in the whole of Europe combined, and many are world leaders in their field. Yet sell-side coverage of Japanese small and mid caps is the thinnest of all developed markets, and mispricings are dramatic. The space has had a difficult four or five years, partly because of the BOJ’s equity purchase programme — a policy that other central banks haven’t followed, and which resulted in Japan’s central bank becoming the largest owner of Japanese equities last December. But as the buying programme is coming to an end, so too should the distortions that it created in the price-discovery process. This should encourage increased investment in small- and mid-cap stocks.
I believe that the really well-managed companies in the space have the ability to outperform in the tougher environment of higher input and labour costs because they can innovate effectively and hire the most talented people. With competition for labour increasing, the better-quality companies are attracting the best employees because they can pay more and offer more flexible working environments. In addition, many Japanese companies are investing in automation at an accelerating pace in the face of labour scarcity and rising wages. As well as the growing density of robot penetration, we’re seeing the broadening of robot adoption from the automotive and electronics industries to other end markets such as general manufacturing, logistics, metal processing and food & beverages.
Relative to the rest of the world, the Japanese equity market, and the small- and mid-cap sector in particular, appears increasingly attractive. Valuations are at decade lows relative to other developed markets and a currency tailwind is helping to support the export sector. Profitability is continuing to trend upwards (as it has from low levels over the past decade) and is now at a similar level to Europe and just behind the US. There have also been significant changes in the corporate governance landscape in Japan, with corporates now paying out more of the cash they’ve generated, either in the form of dividends or buying back stock.
At the same time, with Japan starting to reopen its borders, along with China, a cyclical rebound is just beginning, and economic activity is picking up. In this environment, I expect a number of high-quality small- and mid-cap stocks to grow into much stronger, larger companies, driving further efficiencies and higher corporate earnings. But an investment cycle needs to drive this efficiency push. Rising input and wage costs as well as difficulties sourcing labour should provide the stimulus needed to kickstart that process.
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