Thirty years ago, Japan’s Imperial Palace was rumoured to be worth more than the combined value of all of the property in California. Meanwhile, the country’s stock market had risen from just over 6,500 points a decade earlier to close at almost 39,000 points at the end of 1989. The country, it seemed, was enjoying a period of growth that could one day make it the epicentre of the world economy.
However, an exceptional boom was followed by a catastrophic bust. Japan’s economy experienced a truly disastrous period that included weak GDP growth, deflation and a prolonged collapse in asset prices.
Although this has been referred to as a ‘lost decade’, it lasted for in excess of 20 years. Even 30 years on, its stock market continues to trade at around half of its 1989 level, while its GDP is still below the level recorded in 1995.
Under current prime minister Shinzō Abe, Japan has sought to boost its economic performance through a variety of measures that have included fiscal stimulus and structural reform. While they proved to be somewhat successful in the early part of Abe’s Premiership, they have subsequently failed to deliver growth in line with previous targets.
With demographic challenges, as well as an uncertain economic and political outlook, Japan’s investment prospects appear to be risky. However, with it being the world’s third-largest economy and its stock market now appearing to offer better value for money than it did 30 years ago, it could offer diversification potential for UK-based investors.
The ‘lost decade’
As is often the case with financial crises, the seeds of Japan’s ‘lost decade’ were sown in the years prior to the bursting of its asset bubble in the early 1990s. Key to the creation of Japan’s asset bubble was the 1985 Plaza Accord. This was an agreement between the US, UK, Germany, France and Japan to weaken the US dollar in order to boost US exports. The agreement had a significant impact on the Japanese yen, with it appreciating from ¥262/$1 in early 1985 to ¥127/$1 by early 1988.
In response to a stronger yen, Japan pursued an aggressive monetary policy that led to a halving of interest rates in the two years to 1987. It undertook this policy action in an attempt to limit the appreciation of the yen versus the dollar, since Japan is an export-led economy that generally benefits from a weak currency making its exports more competitive.
A low Japanese interest rate encouraged borrowing at a time when confidence among the company’s businesses and consumers was relatively high. This led to an increasing amount of speculation, with land and real estate often being used as collateral in order to invest in the country’s stock market.
The result of this was that the country’s flagship Nikkei 225 index surged from 11,542 points at the start of 1985 to reach a record high of 38,916 points by the last trading day of 1989. During this period, land in Tokyo was rumoured to have sold for as much as $750,000 per square metre, with Japanese businesses and consumers becoming increasingly desperate to capitalise on seemingly never- ending asset price growth.
Although the Bank of Japan, Japan’s central bank, increased interest rates in 1989 in an attempt to cool the economy’s rampant growth, it proved to be too little, too late.
This, though, was not its only major policy error. Following the stock market crash and the bursting of the real estate bubble in the early 1990s, the Bank of Japan failed to lower the country’s interest rate quickly enough in order to provide the stimulus which the country needed following a severe decline in asset prices.
As a result, Japan experienced a period of economic turbulence that included deflation, weak asset prices and lacklustre GDP growth. Although it sought to counteract the financial difficulties it faced with a 0% interest rate policy in 1999, as well as quantitative easing being commenced in 2001, ultimately its ‘lost decade’ was followed by a further decade of poor economic performance relative to its major industrialised peers.
Following two decades of flirting with deflation, recording weak GDP growth and experiencing falling asset prices, the country turned to a new prime minister, Shinzō Abe, in 2012. He promised to counter the country’s economic woes through a radical three-arrow approach which was dubbed ‘Abenomics’.
The three arrows were targeted on monetary easing, fiscal stimulus and structural reforms. As part of the monetary easing strategy, the Bank of Japan sought to weaken the yen through a quantitative easing programme. This targeted an inflation rate of 2%, and was relatively successful in the first years of Abe’s premiership.
Abe’s fiscal stimulus package totalled ¥10.3trn, and was announced in early 2013. Its aim was to complement private spending in the economy in order to stimulate growth. The fiscal stimulus package was partially paid for through an increase in consumption tax from 5% to 8%, which was somewhat controversial due to its potential to limit consumer spending at a time when the economy was suffering from prolonged deflation and weak consumer sentiment.
Alongside monetary policy easing and fiscal stimulus, Abe sought to introduce structural reforms to the Japanese economy in order to improve its competitiveness. They included regulatory reforms to industries such as farming and healthcare, as well as changes to employment law in order to seek to counter Japan’s persistent demographic challenges, such as an ageing population.
In the early part of Abe’s premiership, the impact of a loose monetary policy and a major fiscal stimulus package was positive. It led to a spike in the rate of inflation, with it reaching almost 4% in 2014, while GDP growth increased to 2% in 2013. Furthermore, the Nikkei 225, having been trading at around 10,000 points when Abe became Prime Minister, had risen by 60% to trade at around 16,000 points one year later.
The recent performance of Japan’s economy, though, has been somewhat mixed. For example, inflation has failed to reach its 2% target since 2015, while GDP growth has been persistently below the 3% target set by Abe throughout his time in office.
He has experienced difficulties in implementing structural reforms to boost the performance of the economy, while factors such as uncertainty in the global macroeconomic outlook and the withdrawal of the US from the proposed Trans-Pacific Partnership trade agreement have hurt the country’s economic performance.
The prospects for the Japanese economy continue to be relatively uncertain. According to the IMF, the country’s economic growth rate is expected to be 0.9% in 2019, and is set to decline to 0.4% in 2020. This compares unfavourably with the IMF’s growth forecasts for even the Brexit-hit UK, which is expected to grow by 1.3% in 2019 and by 1.4% in 2020.
A key challenge facing Japan is its unfavourable demographics. Its fertility rate declined to below 2.07, which is the level widely recognised as being required to maintain a population size, in the mid- 1970s. It has failed to reach this level ever since, with it falling to 1.43 in 2017. When combined with the fact that 25.9% of Japan’s population is aged 65 or above, growing financial pressure on a workforce that is shrinking in size could be ahead.
Abe has sought to counter a continued decline in the fertility rate through establishing a target of raising it to 1.8 by 2025. In order to facilitate this, he has introduced policies such as making preschool education free as part of an overall aim to reduce the cost of having children. This, alongside economic insecurity, are key contributors to the country’s low birth rate.
However, even if the country’s fertility rate experiences an unlikely rapid rise, increased taxes on Japan’s workforce may be ahead in order to fund its ageing population. Since the country has a conservative policy towards immigration, with just 2% of its population being foreign born compared to 14% in the UK, its demographic challenges may persist over the long run.
In the meantime, Japan faces a period of political change. Abe’s third term as leader of the ruling Liberal Democratic party comes to an end in 2021. Under current rules, a fourth term is not allowed. Therefore, a new prime minister will be in place over the next couple of years. This brings the potential for changes in the country’s economic policy.
With Japan having a history of conservatism, and Abenomics’ results having arguably been less positive than initially anticipated, a more restrictive fiscal policy and social reform programme may be ahead.
In the near term, risks such as the potential impact on consumer sentiment of a rise in the country’s consumption tax from 8% to 10% could hold back the prospects for Japan’s economy. Likewise, the ongoing trade dispute between the US and China may lead to further challenges for the country’s economy.
Next year’s Olympic Games in Japan are expected to provide a tourism boost for the country.
Since Tokyo was chosen as the host city in 2013, tourism numbers have gathered momentum. In 2018, for instance, they increased by 8.7% versus the previous year. The government’s original target of 20 million visitors per year has already been surpassed, with annual total tourist numbers to Japan now expected to reach around 40 million in 2020.
Rising tourist numbers contributed to record total tourist spending in 2018, with each visitor spending ¥153,000 on average. Abe’s expanded consumption tax exemptions for tourists, as well as a relaxation of visa requirements on Chinese tourists, could lead to further growth in the country’s tourism industry.
In terms of the investment appeal of Japan’s stock market, its valuation provides guidance to investors regarding a potential margin of safety. While the country’s flagship Nikkei index currently trades at around half of the record level that it achieved in 1989, it offers significantly greater value for investors than it did 30 years ago.
In 1989, for example, the country’s First Section of companies (which is made up of large-cap shares) had a price-earnings (p/e) ratio in excess of 70. Today, its p/e ratio stands at around 19.7. This compares favourably to the S&P 500’s p/e ratio of 21.3. Furthermore, it suggests that even after doubling in price since Abe became Prime Minister in 2012, Japan’s stock market may contain a number of companies that offer good value for money.
The prospects for the Japanese stock market continue to be highly unpredictable and uncertain.
Thirty years may have passed since the peak of its asset price bubble, but Japan’s economy continues to face slow growth, deflationary risks and demographic challenges. Together, they could mean that the country’s ‘lost decade’ continues for many years.
Of course, as the world’s third- largest economy, diversifying internationally through Japanese shares could still hold appeal for long- term investors.
Its stock market has surged higher under Abe’s premiership, and yet continues to trade on a lower valuation than the S&P 500. With it being highly accessible to UK- based investors, gaining exposure could be worthwhile for investors who are bullish about Japan’s economic outlook.
For most investors, though, a cautious approach to its prospects ahead of political change, weak growth and a decline in the size of its working population could be merited.
UK-based investors who wish to gain exposure to Japan’s stock market have a range of options through which to achieve their goal.
For example, many UK-based share dealing providers are able to deal in Japanese-listed stocks. They may, however, charge significant fees in some cases for this service, which could offset a portion of the returns which are available over the long run.
Therefore, investing in an investment trust or a unit trust could be a worthwhile idea. Not only could they provide greater diversity than a private investor is able to achieve through buying direct equities, they also provide an investor with access to a research team that is able to monitor events in the country during what may prove to be a crucial period from an economic and political perspective. Since a number of prominent Japan-focused investment trusts currently trade at discounts to their net asset value, they may offer good value for money.
Of course, the simplest means of gaining exposure to Japan’s economy is through an index tracker fund. There are a number of ETFs available to serve this purpose, with investors potentially best served by a tracker fund that aims to mirror the performance of the TOPIX index, rather than the country’s flagship Nikkei 225.
The TOPIX index includes over 2,000 large-cap Japanese shares, which makes it more reflective of the wider economy than the Nikkei 225. The TOPIX index is also weighted by market capitalisation, rather than being a price-weighted index as is the case with the Nikkei 225. This means that the impact of the TOPIX index’s constituents on its performance is more similar to their effect on the wider economy’s growth rate.
As with any investment in non-UK listed companies, foreign exchange fluctuations can impact on an investor’s returns. Over the last few years, for example, sterling has weakened versus the yen. This has increased returns on Japanese-listed companies for existing UK-based investors, which would not have been possible if hedging had been employed.
The sterling/yen exchange rate could experience a period of volatility over the medium term. Political change in both countries, as well as an uncertain economic outlook, means that failing to hedge returns could produce a volatile experience for UK-based investors.
The continued strength of the yen versus a basket of major currencies may be surprising to many investors. After all, the Japanese economy has failed to meet its economic targets under prime minister Abe, with it struggling to deliver GDP growth over the last few years. Moreover, the IMF’s forecasts for 2019 and 2020 suggest that Japan’s economic growth is slowing, and a continued loose monetary policy may be required in order to support the economy.
The yen, though, could experience high demand among investors due to its safe haven status. Since Japan has a current account surplus (its exports are greater than its imports), it is a net creditor to the global economy. Foreign assets owned by Japanese-based investors are greater in value than Japanese assets owned by foreign-based investors. This means that when the world economy experiences an uncertain period, capital flows back to Japan and increases demand for the yen relative to other currencies.
In addition, the country’s persistently low interest rates have made it attractive for investors to borrow capital in Japan, and invest it in other economies that offer higher interest rates. This is known as a ‘carry trade’. Should global economic uncertainty rise, the unwinding of carry trades means that demand for the yen is likely to rise. This could cause a further appreciation in its value compared to other currencies.
Robert Stephens is a former analyst and now a full-time financial writer.