Japanese Equities - Attractive Valuations and Rising Return on Equity

Would you please discuss the Bank of Japan’s actions regarding the yield curve control policy?

In December, the Bank of Japan abruptly changed the yield curve control policy. Previously, the 10-year yield was pegged at 0% with a “move” range of 20 to 25 basis points through the central bank’s aggressive bond purchasing. Now, it has been increased from 25 to 50 basis points.

While many investors thought this action signaled that the Bank of Japan was finally starting to raise interest rates, the central bank indicated it changed the policy because of the declining market functionality and volatility as well as a lack of liquidity. 

We believe there was another reason, which was rising inflation due to Japan’s commitment to the ultra-low rate environment. There was a widening of interest rates between the U.S. and Japan, which resulted in the weakness of the Japanese currency and higher input costs. With households affected by higher costs coupled with negative real wage growth, the Bank of Japan may have had to allay consumers’ concerns.

Do you believe Japan’s inflation level will remain elevated?

Yes. Japan’s core consumer price index (CPI) has been trending above 3% since last September, the highest in the last 40 years. Although the Bank of Japan maintains the opinion that the current inflation situation is transitory, we believe Japan’s CPI could continue to remain elevated for the following reasons: 

1.    Price hikes have been implemented by companies in response to higher import and energy costs. Businesses have passed on cost increases to consumers, implementing price hikes on food products, staples, groceries, and durable goods since October 2022.

2.    Consumers are expected to “revenge spend,” due to the belated reopening of the economy. This increased spending will add to the upward pressure of inflation.

3.    A rising number of inbound tourists may visit Japan with the reopening of the borders, which will likely tighten the job market in the hospitality industry. We should also see these overseas visitors spending money in Japan.

4.    Housing rents are expected to rise. In Japan, rent prices have barely moved in the last several decades but we anticipate that they will begin to rise.

Wage growth has been stagnant. What could increase wages in Japan?  

As Japan welcomes an increasing number of tourists into its country, the number of people working in the hospitality industry will not be enough. A tight job market will most likely lower the current unemployment rate from about 2.5% to 2.3%, which is full employment state of the economy.

A tight labor market and full employment could pave the way for labor unions across Japan to negotiate with large companies for higher base salary increases, asking for more raises than the current inflation rate during the upcoming spring wage negotiation season. 

Would you please provide a review of the 2022 Japanese market? 

2022 was a year of significant market rotation from growth to value in Japan, similar to other major markets around the world. The best performing sectors were banking and insurance as they are a direct beneficiary of rising interest rates, even though Japanese rates did not move much during the year. In December, the Bank of Japan’s decision to change the yield curve control measure was taken as a signal of higher interest rates in the near future, which triggered many banks and insurance companies to perform very strongly at the end of last year.

In contrast, large growth companies—the area of the market where the Hennessy Japan Fund focuses—suffered the most as a result. Regardless, our growth investment style remains unchanged. We believe the Fund’s holdings remain sound with durable competitive advantages that will allow them to grow at a faster-than-average pace in years to come.

What do you anticipate for the reopening of Japan’s economy?

Looking ahead to 2023, Japan could remain resilient because of its belated reopening of the economy. Japan is an attractive destination for global tourists, so we anticipate a sharp increase in the number of visitors to Japan. There were about 30 million tourists visiting Japan at the peak in 2019, and if the country returns to that level, with each person spending about $1,500, the aggregate contribution to the economy could be about $40 billion or about 1% of Japan’s GDP. 

Would you please discuss Japan valuations and return on equity?

We believe Japan continues to trade at attractive valuations. The price to earnings (P/E) of the Tokyo Stock Price Index is trading at 12x on a forward earnings basis with a price to book of about 1.1x and a return on equity (ROE) of about 9%.

Since 2015, Japan’s ROE has been on a rising trend due to various corporate reform initiatives. Prior to the beginning of Abenomics, Japan’s return on equity was only 5%. Now companies are much more focused on key growth metrics such as return on equity and return on invested capital, which is different from their thinking 20 or 30 years ago. With the continuous efforts on corporate governance reforms and initiatives, we believe Japan’s ROE will continue to improve, rising past 10% to the low teens in the next  5 to 10 years.

Another way to look at Japan’s valuation is the relationship between market appreciation and corporate earnings growth. From the beginning of 2013 through the end of 2022, the market appreciated roughly 170% and corporate earnings per share increased about 190%. Therefore, the market has not kept pace with the corporate earnings performance.