Japan’s economy has been fraught with periods of deflation and stagflation for years, including the so-called lost decade, which has turned many international investors away. The election of Prime Minister Shinzo Abe sparked hopes that the country could turn its economy around, but the progress has been slower than many have hoped. The good news is that there are some important catalysts that could help the country outperform over the coming years.
In this article, we will look at three reasons that investors may want to consider investing in Japan over the coming years.
- Gains in the value of the U.S. dollar against the yen and "Abenomics" have contributed to an increase in Japan's growth.
- Japan has been a leader in robotics and technology for many years, but its large tech companies are losing market capacity.
- Japan's economy and fiscal and monetary policies should be watched for signs of recovery over the next few years.
1. Federal Reserve Rate Hikes
Japanese stocks received an unexpected boost in November 2016 when Donald Trump’s victory sent the U.S. dollar soaring—and the yen toppling. The weaker yen helped bolster Japanese stocks, which outperformed many developed countries in the weeks following the election. Since then, Japanese stocks have underperformed U.S. equities as the dollar has given up much of its gains between January 2017 through late-May 2017.
The Federal Reserve has indicated that it’s ready to continue hiking interest rates given robust employment figures and solid economic growth throughout 2016 and 2017—except for a Q1 2017 stumble. Meanwhile, the Bank of Japan is likely to keep interest rates low and risk overshooting its 2% inflation target to get consumers used to seeing higher prices after years of deflation. These dynamics could help boost Japanese equities over the coming years.
The weaker yen helps Japanese exporters become more competitive in international markets—including the United States—and therefore helps bolster corporate profits. International investors should use currency-hedged funds to maximize the gains from these dynamics, since these funds offset the impact of a weaker yen upon conversion back into dollars. For example, the iShares Japan Currency-Hedged ETF (HEWJ) is a popular option.
2. Abenomics Is Slowly Working
Shinzo Abe’s economic policies—known as "Abenomics"—may have been slow to start, but there have been real improvements in the underlying economy. The policy’s stated goal was to use monetary easing, fiscal stimulus, and structural reforms to jolt the economy out of the "suspended animation" that has affected it for more than two decades. The first two "arrows" were relatively easy to implement, but structural reforms have been slow to materialize.
Japanese inflation initially rose past 3% by 2014 in response to the policy, but eventually fell back below 0% by 2016. In 2017, inflation began to rise once again to around 0.2% after the central bank said it would make yield curve control a central component of its new policy framework. The goal was to purchase 10-year government bonds to keep yields at 0% while abandoning its official target for expanding the monetary base.
The prospect for higher inflation could boost the outlook for Japanese stocks and the wider economy, while an end to decades of deflation and stagflation could lead international investors back into the market. International investors should keep an eye on both headline inflation rates and progress being made on the more-difficult third arrow of Abenomics—structural reforms that have yet to fully take place.
3. Technology Leadership
Japan has always been known as a leader in robotics and technology, but this is often through medium-sized firms rather than multinational giants. For example, a firm called Nidec produces about 75% of motors used in hard disk drives, while TEL makes 80% of the etchers used in making LCD displays. While big companies like Sharp, Sony, and Panasonic have been losing market share to other firms, these smaller companies continue to dominate their niches.
Many of these companies also have much larger barriers to entry compared to foreign companies. For instance, many Japanese companies manufacture high-end components in their own factories and often own their own supply chains. The strength of these companies lies in their employees rather than patents that eventually expire or network effects that rely on consumer behavior not necessarily changing over time.
International investors may find these medium-sized companies compelling opportunities for stability over time as opposed to fast-growth companies that could be more susceptible to crashes. Still, investors should be aware that many of the country’s larger companies are suffering from market share loss, which means that traditional market-cap-weighted funds may not be the right choice for investing in these companies.
International investors should keep in mind that Japan still faces several challenges over the years. With an aging population, the country faces a significant demographic problem that will only be solved through immigration reform—a tough sell politically. The country also has high levels of debt, compared to its gross domestic product (GDP), which could put the country at risk over the long run if credit analysts decide it could have difficulty repaying debt.
The Bottom Line
Japan may not seem like an obvious choice for international investors, but there are several potential catalysts on the horizon over the coming years that could make it more attractive. This is especially true if the country can resolve its inflation-related problems through Abenomics and if the U.S. continues to raise interest rates.