[Editor’s Note: Do not read the following article as a recommendation to buy Japanese equities or sell US equities. Talk to a licensed financial adviser or do further research of your own before acting on themes in this article. Like all investments, global equities have risks. Persistent higher-than-expected inflation and interest rates could affect global equity valuations. Currency risk is another consideration for Australian investors who invest in global equities (and are unhedged for currency movements)].
The Japanese stock market has rallied in 2023, with the Nikkei 225 up 25% for the year to 22 September , outperforming most major market indices.
Up until mid-2023, global investors had bought ¥7.2 trillion (US$50 billion) on a net basis this year , which is a major reversal of prior trends. Global investors avoided Japan for the best part of a decade, with cumulative net selling of Japanese equities by foreigners to the tune of ¥29 trillion (US$200 billion) over the period 2015-2022 .
The last time foreign investors were this enamoured with Japan coincided with the appointment of the reformist Shinzo Abe as Prime Minister in late 2012. His plans to restructure the Japanese economy and end deflation via massive monetary stimulus caused investors great excitement and led to the Japanese stock market doubling over a two-year period.
This excitement turned to boredom and ultimately disillusionment as structural reforms were more gradual and took longer to deliver results than initially hoped.
However, what global investors missed was the real fundamental change taking place under the surface of the stock market headline: A reform snowball that slowly gathered size and speed until it built the momentum to achieve breakout velocity on the back of two key events:
Investor complaints about Japanese business practices have been consistent for the last few decades. Decisions have not been made with shareholders in mind, in Platinum’s opinion. Rather, companies have pursued growth, even where it was unprofitable to do so, and hoarded capital as this was viewed as costless.
Some entrenched management teams adopted whatever strategy they wished, with flowery language and little regard for shareholder wishes or basic economic realities, in Platinum’s opinion.
This situation arose from the model adopted for post-war reconstruction and development, which involved an alliance between government and corporate management against the power of labour.
Companies were financed by state-directed lending rather than equity markets, with a focus on the growth of the enterprise and Japan as a whole rather than returns on shareholder equity. This was supported by significant cross-shareholdings between members of “Keiretsu” groups, which curtailed the influence of outside shareholders, as management could always count on a high level of voting support from these friendly parties.
Arguably, this model worked well for Japan until the 1980s, but by the 2000s, key parts of the government realised it had outlived its usefulness and sought reform. There has since been a significant decrease in the levels of cross-shareholdings.
In recent years, the focus of reform has been to give power to foreign shareholders to push for improvement via twin Governance and Stewardship codes. Compliance with these codes is voluntary, but a significant nudge element is involved, which is effective in the Japanese context where peer pressure can be highly motivating.
The Governance Code outlines best practice that companies should move toward and provides reference ammunition for dissatisfied shareholders in conversations with management teams. Asset managers who sign the Stewardship Code (which includes all the Japanese majors) must disclose their voting records, and as a result, are gradually moving to voting behaviour that benefits their unitholders rather than the relationship the asset manager’s parent bank may have with the investee company.
This cultural shift in Japanese corporate circles comes at the same time as US political leadership aims at re-shoring production in an attempt to lower dependence on Chinese manufacturing, amid dramatically higher interest rates, higher inflation, and likely ongoing higher capital expenditures globally, in Platnium’s view. This could potentially benefit Japanese companies, many of which maintain strong positions based on technical expertise and operational efficiency. As such, Platinum believes the outlook for Japanese equities has improved.
On the other hand, Platinum remains cautious about US equities at the broad index level. US equities have delighted in the avoidance of a recession in the US so far. The skirting of a recession to date has been far from miraculous: the US Federal government has printed a deficit of 8.5% of Gross Domestic Product for the economy to grow at 2% for the year to date, stripping out inflation, according to Platinum analysis.
The budget deficit is the third-largest trough deficit in US peacetime history. In recent weeks, US equities have begun to sniff out what Platinum believes is a fundamental truth: you can have growth funded by massive government deficits or low rates and high equity multiples ... but you can't have both.
Over the long run, fundamental economic truths matter. In 2021, many believed that inflation was transitory – that proved to be wrong.
Simultaneously, many believed that rates could never go up because the system was too sensitive to interest rates – that was also wrong.
In 2023, there appears to have been an emerging view that investors do not need to worry about the “crowding out” effect of colossal bond issuance by the US government – that the long end of the yield curve will never go up, in effect. Again, we think this is dangerously wrong. In recent months, the Nasdaq has sold off as the US 10-year Treasury yield leapt higher, by bond market standards, from 3.75% to 4.5% .
Simply put, Platinum believes US equities are now placed at historically high valuations in the face of a conundrum: ongoing debt-funded government largesse and higher rates, or a modicum of fiscal rectitude and recession.
Either way, Platinum believes the party in US equities is, once again, ending in the face of the re-assertion of an economic truth: high bond yields are not good for equity market multiples.
 Osaka Stock Exchange, Tokyo Stock Exchange, Nomura. Two cash markets plus futures, in net terms this year from 1 January to 16 June 2023.
This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006 AFSL 221935 trading as Platinum Asset Management (“Platinum”).
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Commentary reflects Platinum’s views and beliefs at the time of preparation, which are subject to change without notice. Commentary may also contain forward-looking statements. These forward-looking statements have been made based upon Platinum’s expectations and beliefs. No assurance is given that future developments will be in accordance with Platinum’s expectations. Actual outcomes could differ materially from those expected by Platinum.
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