The EPFR Exchange Podcast

Japan Equities: From a dark to sunlit investment trap, feat. Pictet Asset Management Jon Withaar

September 11, 2023 Kirsten Longbottom & Cameron Brandt & Jon Withaar Season 3 Episode 3
The EPFR Exchange Podcast
Japan Equities: From a dark to sunlit investment trap, feat. Pictet Asset Management Jon Withaar
Show Notes Transcript

China clearly holds the crown among Emerging Market Equity markets when it comes to attracting fund flows this year. In the struggling Developed Market universe, meanwhile, Japan is breaking free of the pack. Japan Equity Funds have recorded inflows 11 of the past 12 weeks, and Japan Dividend and ESG Funds have done even better with flows to the former picking up significantly in mid-March and those to Japan ESG Funds lofting off at the start of February.  Yet, the lag in response to increasingly rosy market conditions and the minimal changes that Global and Global ex-US Funds have made to their Japanese exposure, hints at a degree of skepticism.

In this episode, Research Associate Kirsten Longbottom and Director of Research Cameron Brandt invite Pictet Asset Management's Senior Portfolio Manager Jon Withaar to discuss these themes and trends.

We look back at 2015 when the corporate governance code was introduced, discuss the current, relatively cheap valuations of Japanese assets, explore what bad inflation looks like for Japan, examine the linkages between Japan and China in the long term, ask where the Bank of Japan will go from here and delve into the benefits of a weak Yen versus strong Dollar.

More from EPFR on Japan:

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0:00 Intro
This is the EPFR Exchange Podcast. All opinions expressed by Cam, Kirsten, or our podcast guests are solely their own opinions and do not reflect the opinion of EPFR. This podcast is for informational purposes only and should not be relied upon for investment decisions.

0:18 Kirsten Longbottom
Hello everyone, I'm Kirsten Longbottom from EPFR's research team and I'm joined on today's Exchange Podcast by Jon Withaar from Pictet Asset Management and EPFR Research Director Cameron Brandt, welcome both.

0:34 Jon Withaar
Thank you very much.

0:35 Cameron Brandt
Good to be here.

0:37 Kirsten Longbottom
Today’s discussion will center on a market that Warren Buffet believes has a lot of good businesses trading below their fair value. His remarks earlier this year about Japan, and the value it currently offers, helped propel Japan’s benchmark equity index to a more than 30-year high.

Japan, lest we forget, has endured a ‘lost decade’ that spanned over 30 years, has an aging population that shrank by over 750,000 last year, imports nearly 100% of the oil it uses and has a national debt equal to 265% of GDP.

Before we dive into the question of Japan’s transition from dark value trap to sunlit investor-friendly uplands, I’d like to welcome Jon and ask him to tell us a bit about his background.

1:31 Jon Withaar
Thanks very much, Kirsten. Thanks for having me. My name is Jon Withaar, I manage the Lotus Fund within Pictet Asset Management, I'm based in Singapore, and I've been managing money in the market since about the year 2000 so about 23 years now and feeling every euro in the hidden markets like this. Our focus is on special situations. So, we look at sort of corporate transactions, corporate change, and overall, the large picture trends that we see emerging, particularly in the Asian region.

2:04 Kirsten Longbottom
Well, I'm excited to kind of pick your brain of different areas that you're focusing on. Cam, as we usually do, can you set the stage based on what we've seen in EPFR's Flows and Allocation data?

2:18 Cameron Brandt
Sure, Kirsten. Well, so far 2023 has been a dismal year for most Developed Markets Equity Funds. Collectively, they recorded an outflow of over $80 billion, while their Emerging Markets counterparts -- with China mandated funds well to the fore -- have attracted over $90 billion. Within that somewhat struggling DM fund universe, however, if there's a star, it's Japan Equity Funds.

Although investors waited a couple of months before buying into the soaring Nikkei index, since the beginning of June the Japan Equity Funds we track have recorded inflows 11 of the past 12 weeks. Japan Dividend Funds have done better, with flows picking up significantly in mid-March and flows into Japan ESG Funds picked up even earlier around the beginning of February.

The overall lag in response to the increasingly rosy market conditions, and the minimal changes that Global and Global ex-US Funds have made to their Japanese exposure, does highlight a point that I think will be up for discussion today. Which is that, with Japan, we've been here before – Shinzo Abe “three arrows” launched in 2013, for instance – and it usually hasn't ended that well for investors. So, there’s certainly a degree of residual skepticism here, born of experience.

But what we're seeing in the flows, the presence finally of sustained inflation, Buffett's vote of confidence, the combined impact of reforms enacted over the past decade, what are still the most accommodative monetary policies among the major developed markets – and indeed, most emerging markets – and the search for alternatives to a struggling China all suggests, to me anyway, that Japan is at another inflection point, and this one might be different.

4:29 Kirsten Longbottom
Thinking this time will be different is a classic investment trap in its own right. But it does happen. Jon, do you think this is one of those times?

4:40 Jon Withaar
We do, we're pretty convinced that Japan is turning a corner. All these things are cycles, and we've seen many cycles, just like the cycle we’ve seen play out in China right now. But I think this time around we're very encouraged by what we’ve seen. And if we take our minds back to where at least this most recent rally germinated, it came from 2015, and the introduction of corporate governance code. In 2015, we saw a lot of changes put into place that were the beginning of what we're seeing right now: that was things like shareholder engagement policies, mandates for independent directors on boards, mandates for disclosing cross shareholdings. It basically opened the wider discussion about shareholder governance and corporate governance. 

And ultimately, what we're seeing now based on this foundation has also come at a great time. As you said, we're seeing a struggle in China. At the same time also, we're seeing a resurgent Japanese economy as well.

As we sort of spoke about the other day, we have seen at least the beginning stages of some healthy inflation. We saw 4% print plus earlier in the year and it's still well above the 2% level. We're also seeing wage negotiations going very, very well. So, wages are moving up. We saw wages move up at the highest rate in over 30 years. And because of the corporate reforms, we're also seeing shareholder returns turn up. 

Now, I think it's important to take a step back and ask, how expensive or cheap is Japan? Well, Japan is trading around about a 13 to 14 times PE. Most companies in Japan are net cash and 50% of the the TOPIX index is below 1 times price to book. So, we're actually starting from quite a cheap place. Certainly, Japan is the cheapest developed market out there. And if you compare that to the US, where you have 20+ times PE, we've got value as well.

To sum up, what you have is you have a market that has low interest rates, where the macro environment is providing support and a tailwind. We have the yen which is point is providing a tailwind as well to this export driven economy. And then we have value. We have value in terms of PE, we have value in terms of price to book, and more importantly, we have strong balance sheets. So, we have companies that can weather this interest rate move that we're seeing everywhere else in the world. 

Is this time different? Well, as you say there's a bit of a trap in saying that. But certainly, we think the foundation is there. And I guess the final thing is that there has been an element of capital flight out of markets like China where many people are concerned about the macro environment, about the property markets and the LGFV (local government financing vehicles) situation there. So, a lot of that money that's seeking safe havens is going to Japan when you do have that value case.

7:43 Kirsten Longbottom
If wage growth is generating good inflation, what does bad inflation look like? And what are the chances that Japan will have to deal with it?

7:59 Jon Withaar
That's a great question. I think bad inflation is that sort of cost-of-living inflation that we were dreading, and certainly we're seeing in many parts of the world. Here in Singapore, we're seeing a little bit of it, and on my last trip to New York I encountered it as well. So yeah, there is that bad or cost-of-living inflation that really eats into wages and into consumption. We're not there yet in Japan. We're certainly not seeing a big spike in the price of things like residences, accommodation, food and that kind of thing. But it's something to keep an eye on. 

I think one thing that will ameliorate concerns there is the fact that China is exporting to a fair bit of its own deflation, and China is obviously a large trading partner of Japan. But ultimately, it's something that the Bank of Japan is very, very concerned about. They are still quite cautious on the bull case. This movement of the yield curve band that we've seen really was a recognition of the direction that we're moving, but it certainly wasn't a panic stations type move. So, we've got an eye out for that. And I think the Bank of Japan does as well. But for the moment, we're not seeing it.

9:20 Cameron Brandt
Can I jump in here, Jon, and ask you a little bit more about the China angle of your analysis? I know it's certainly tempting to see China's growing problems as an opportunity for Japan. I can certainly see the case in the short run, especially given the search for more hospitable offshoring bases. But China's economic pathologies in many ways mirror those of Japan – an aging and declining population, high debt levels spent on infrastructure that there aren’t as many people around to use, limited domestic supplies of raw materials. How do you think the linkages between Japan and China play out sort of over a longer period, say five years?

10:14 Jon Withaar
Yeah, that's a great question. I think, Cameron, geopolitical concerns aside, because we can't really forecast those, there is a linkage between the two. But that being said, I think that they are on different trajectories.

We've seen that in the past. The two can decouple, the two can be separate and if you take the last 20 years as an example, we saw, effectively double-digit GDP growth in China, spectacular industrialization and a transition towards a consumer driven economy while you were dealing with deflation or very close to it in Japan for extended period of times. So, the two can trade and operate differently within their own different macroeconomic environments.

Now, that's not to say that if we get some kind of a serious credit event in China or elsewhere in the world, that Japan won’t suffer, they will. Japan is a smaller economy than China, but certainly I think that there is, to a certain extent, an argument that can be made that would suggest that the two can and have decoupled, at least to a certain extent.

11:21 Kirsten Longbottom
In Cam's opening remarks, he mentioned flows to Japan ESG funds were the first to pick up. That struck me, as Japan has not always had the easiest relationship with Western environmental, social and governance norms. Yet SRI/ESG investing is a significant driver of investment flows, especially among younger investors. Jon, is this another area where perceptions of Japan lag the actual facts on the ground?

11:51 Jon Withaar
Yes, what I can tell you is that the ESG environment is very much more advanced than it was even 10 years ago, or five years ago, in Japan.

If we take a step back and we look at the 2015 period when we saw the corporate governance reforms introduced, less than 10% of companies in the prime index had a significant share of independent directors on their boards, which is something that we take for granted in the rest of the developed world. But in Japan, that was just not the case. And in fact, it was less than 20% of companies that even had even had two independent directors. Many companies didn't have even one. Now, we see over 90% of companies have independent directors making up a third of their boards. 

In terms of the governance, we're seeing things such as shareholder rights policies; we're seeing shareholder engagement; we're seeing poison pills, which is something that is traditionally seen quite hostile to investors being unwound as well. On the “E” (or environmental) side, it is something they're addressing, and this is simply because the government is really pushing that as well. And we're seeing big improvements on both the E, the S (or social), and the G (or governance) in Japan certainly versus what we saw 5-10 years ago. And we think it's a great trend that we’ll continue to see in the coming years. 

Ultimately, one thing that we have noticed globally is that those companies that recognize ESG is real and take it seriously are rewarded. We've seen that with the outperformance of many ESG indices, etc. that's been rooted in Japan. If you take the first early movers in Japan, for example, groups like a Tai Chi, these groups saw very early outperformance within the overall Japan structure simply because they were being rewarded first by foreign investors and then by the local investors. So we do see change there happening in a very, very positive way and we try to incorporate that into our investment thesis as well.

14:05 Kirsten Longbottom
Cam, would you mind expanding a bit on Japan Equity ESG flows? I believe the story was that they've only had two outflows since mid-February. Am I right in saying that?

14:19 Cameron Brandt
You are right in saying that. They peaked in early July, but that's not, I think, particularly surprising. The market focus has increasingly been on China. So, there's definitely an opportunity for Japan to continue to fly little under the radar at the moment. But the narrative about it remains somewhat fraught and certainly Japanese fund managers I talked to – and I have to admit, I haven't really had this conversation for three or four years – were really struggling with it the last time I had a substantive conversation. So, it was interesting to hear what Jon had to say. 

While I've got the floor, Jon, one thing we haven't talked about here, harkens to another widely held assumption about the Japanese economy, which is that at this point, it's a wholly owned subsidiary of the Bank of Japan. Like many nice sounding remarks, I think that is a little facile. But there's no doubt that the ultra-accommodative monetary policy that the Bank of Japan has kept in place for really the better part of a decade has, until recently, really been the driver of sentiment. Any threats to that set of policies tended to send the market and fund flows in the opposite direction. And the bank still holds – gosh, the numbers are all over the place – certainly half of the available stock of 10-year Japanese government bonds as well as a significant slice of the equity market through its holding of domestic ETF shares. So ,I'd be really interested in your thoughts on where the Bank of Japan goes from here and what investors should be keeping an eye on as the Bank of Japan does, I think, pivot towards a more normal policy. 

16:37 Jon Withaar
Yeah, I mean, that's the million-dollar question ultimately, isn't it? What does the Bank of Japan do? Ultimately, they will be cautious.

But again, to go back to your comment on the accommodative policy and that stance supporting equities, its worth mentioning that they've been accommodative for the better part of two decades and that didn't do much for the market at all, in particular the equity market. Certainly, if you look at that moniker of value trap, that absolutely was true for part of 20 years. And what we're seeing drag the Japanese market out of that now is much less a case of the interest rate environment and much more a case of this corporate governance theme that we're talking about.

So, the corporate governance thematic is very much a self-help type of narrative. You're seeing companies engaging with shareholders, doing things like buybacks, paying dividends at the highest rate they've ever paid them at, etc. And ultimately, a company in Japan that was yielding 5%, they double their payout ratio, and are now yielding 10%. That's an instant rewrite.

Now to get back to what you were saying about the Bank of Japan. Really, it's tough to see what's going on there but they don't want zero interest rates forever. They do want to reflate themselves, that is the goal. And so ultimately, our view is that they are having success at the moment. They are being very cautious about it. The way that moving up the yield curve control band. I think next to go will most likely be the negative interest rate policy, which will obviously be supportive to the financials as well. And ultimately, they’ll just try very, very slowly to reflate their way out of it.

As you very well mentioned, there are risks to this, obviously to the global economy, risks that a US slowdown occurs and sweep this whole thing. China as well, there's a risk there. The path is not set, certainly, there are risks. But as I said earlier, I think the starting point is compelling.

18:46 Cameron Brandt
Thanks. And before I let you go, one last question. Again, this is somewhat of a legacy view but the Yen has also been a significant driver of sentiment. People have really focused on the export side of the Japanese economy and when the Yen was weak versus the Dollar, there was considerable enthusiasm for the usual suspects. If your analysis is right, Japan is going to continue to see more and more portfolio capital flow in and that is likely to strengthen the Yen. How do you see that sort of Yen/export nexus playing out in light of your fairly bullish predictions for Japan?

19:37 Jon Withaar
So, it's a great question, and that is right. I think if it all plays out correctly, we do see rates moving up and as you see that strength in the economy, you will see the Yen strengthen.

At the moment, though, that's not the issue. The Yen is obviously very weak. In fact, people are expecting intervention on the other way from the Yen and this is mostly driven by the strength of the US dollar. But longer-term you are 100% right.

So, how does the Bank of Japan tackle that? I think they're going to take the same very, very measured approach, but they also have to realize that there's also not a hell of a lot they can do here on this, simply because, ultimately, it's a US dollar story.

Now, what does that mean for equity holdings and what does that mean for investments? Well, it's tough to say but there are two observations that I can make here and the first is that, traditionally, if you go back 5-10 years to earlier in my career, the correlation between the Yen and equities, particularly those exporting driven companies, Toyota, etc. was very high. What we've realized is that over the last three to five years, we've seen that correlation break down a little bit. Now, does that mean it's not there? Absolutely not. Because obviously this impacts earnings. But I guess one thing is that the correlation I don't think is as high.

But ultimately, if we are going to go down the bear case, which is at least a possibility in terms of global economy, if we are going to see weakness in the US dollar because of recession, which then means strength in the yen though all asset classes will struggle in that environment.

Then it gets back to my original point that in theory, we're at a better starting point with Japan. We're talking about net cash companies, cheaper PE cheaper price to book, improving corporate governance. So ultimately, from our perspective Japan is in a good place, certainly from a relative standpoint.

 21:45 Cameron Brandt
Jon, in my opening remarks, I mentioned something which certainly struck me which is that despite the soaring performance of Japanese Equity markets this year, and the tailwinds that you've outlined for us, the average Japan allocation among the big diversified global funds, Global and Global ex-US, that has not really budged this year. In fact, in the case of Global Funds it has gone down slightly. What do you make of that? 

22:22 Jon Withaar
Yeah, Cam, that's a great point. From some of the work that we've done, the people that we’ve been speaking to in regard to positioning, whilst we have seen a lot of buying in Japan from foreign investors, a lot of that buying has actually been CTA hedge fund and passive money. And really, we haven't seen long-only, institutional, international investors reallocate to Japan in any significant way.

Certainly, there's a lot more to be done. If you look at the numbers and speak to the people that we were speaking to, many believe that the underweight is around 50 basis points. So, around about $50 to $75 billion US dollars of buying would need to be done for investors, global investors to reach a market of weight. Which is obviously a lot because we're not even talking about overweight, we're just talking about market weight. This is a market that is, obviously it's a liquid market, but $50 to $75 billion, that's a lot and that has market moving action.

So, it's definitely something that we’re taking into account. It is shifting, but I think as you well know, Cameron, these shifts can take some time to translate into stronger market performance.

23:35 Kirsten Longbottom
Great. Well, thank you both for your insight. We've definitely covered quite a bit of ground from inflation to SRI-ESG to dividends to currency at the end there. So, thank you, Jon, for joining us. And thank you, Cam, per usual.

23:53 Jon Withaar
Thank you very much. Thanks for having me.

23:56 Kirsten Longbottom
We invite EPFR and industry experts to discuss timely trends, driving financial markets aimed at arming global investors with a deeper understanding of where money is moving and why. If you have a topic you'd like to discuss for a future episode, or would like to join us for an episode, don't hesitate to reach out to Cam and myself. Jon, we hope to have you back on here. Cam, thanks again.

24:19 Outro
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