Investment Strategy Brief:
Re-Discovering Japan

Below is a transcript of this week’s video.

Hi, This is Jason Pride, Chief of Investment Strategy and Research at Glenmede.

Japanese equities have been on the rise as of late, with Japan’s Nikkei 225 Index is up over 25% since the start of the year, leading many investors as well as financial media to take note. Investors for years had considered Japan to be a value trap, suffering from the aftermath of the late-1980’s bubble and decades of sluggish economic growth. But closer inspection of the longer-term trajectory and circumstances surrounding Japan seem to point to some significant changes that started about 10 years ago.

In fact, over the last 10 years, the earnings of Japanese companies have stealthily outgrown those of their larger international developed market region peer - Europe. Such growth in earnings has supported the growth in stock prices, constantly driving higher the base for valuation, making Japanese equities continue to look cheaper than their peers despite their rising prices.

While difficult to prove, it seems quite possible that the cumulative impact of multiple years of corporate reform may be at least in part responsible. Changes that were initiated by former Prime Minister Shinzo Abe and continue under the coordinated direction of the Japanese government and the Tokyo Stock Exchange have gradually nudged the behavior of corporations in the favor of shareholders. Examples of the impact of these reforms can be seen in the rise in independent directors of Japanese companies as shown in the chart on the left and the increased focus on the shareholder-friendly practice of returning capital to shareholders as evidenced by the rising dividend yield shown in the chart of the right. Greater accountability and discipline is likely a key contributor to the rise in profit margins associated with the rise in earnings seen in the prior chart.

Japan’s longer-term reform story, today, is coinciding with a near-term economic story that also looks more favorable than other parts of the world. Japan’s recent GDP report showed an economy growing 2.7% on a real/inflation-adjusted basis – reasonably good in the current environment – and quite positive compared to borderline-recession results in Europe. Further, on a nominal basis, including inflation, growth was even more notably stronger than trend.

This leads to an interesting observation for Japan. After years of sluggish growth and deflation, recent results create quite a different picture. In fact, they create quite a different set of circumstances and resulting reaction function for Japan’s central bank, the Bank of Japan. Inflation in Japan, like other nations, has risen materially, but this inflation is not quite as pronounced and is arguably more welcome given that Japan has been trying to get out of deflation for quite some time. As a result, the Bank of Japan has been far more hesitant to react and raise rates as others have done. This is likely to result in less of a headwind for the Japanese economy.

Given the rise in Japanese equities this year and the growing attention it has received, it would be justifiable for investors to question if all of this has been priced in at this point. Based on Glenmede Global Expected Returns model, the answer is a clear no. Japanese equities continue to trade at a sizeable discount to our assessment of fair value for the region while most other regions trade closer to or above fair value. It may take some time for investors that have been taught for decades not to fall into the Japan value trap to come to realize that it may not be a trap anymore.

Lastly, when investing abroad, one also always needs to take into account the currency. And while it is hard to predict currencies since they follow such long-term swings in appreciation and decline, one can occasionally find situations in which a currency’s move has gone too far. Such appears to be the case for yen, which is now trading two standard deviations away from its longer-term relationship to the dollar, as shown in this chart.

So in summary:

• Japan has seen a rise in investor interest and recognition in the press
• Earnings of Japanese corporations have been quietly outpacing their European counterparts
• Earnings improvement is at least in part the result of years of corporate reforms that are likely to continue to influence performance
• The Japanese economy appears relatively healthy as the rise in inflation has been more favorable than in other countries/regions
• Valuations of Japanese companies and the yen itself suggest that investment opportunities remain

Thanks for listening! And please don’t hesitate to reach out with any questions.

This material is intended to review matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. When provided to a client, advice is based on the client’s unique circumstances and may differ substantially from any general recommendations, suggestions or other considerations included in this material. Any opinions, recommendations, expectations or projections herein are based on information available at the time of publication and may change thereafter. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Outcomes (including performance) may differ materially from any expectations and projections noted herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss any matter discussed herein with their Glenmede representative.