Inflation, what inflation?

Investment company managers on prospects for Japan.

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Long-term investors in Japan have endured several false dawns since the Nikkei 225 index peaked at above 38,900 in 1989, never to return to those heady levels. But with deflationary pressures having dogged Japan’s central bank for decades, could a burst of inflation actually be good for its economy and stock market?

Japan’s core consumer price index was up 1.9% in April versus a year earlier, just below the official target of 2%. The Bank of Japan has not deviated from its ultra-easy monetary policy by keeping short-term interest rates at minus 0.1% and continuing its bond-buying programme.

The Association of Investment Companies (AIC) has collated comments from investment company managers in the Japan and Japanese Smaller Companies sectors, as well as managers in the Global sectors with significant exposure to Japan, to assess the outlook for Japanese equities.

Discounts on Japan-focused investment companies have widened, standing at 8.1% for the Japan sector and 5.5% for Japanese Smaller Companies. A table showing discounts and performance of all companies in these sectors can be found at the bottom of this release.

Impact of inflation

Richard Aston, Manager of CC Japan Income & Growth, said: “Japan has long been considered a potential beneficiary of inflationary forces given that deflation has ruled for many years. However, it all depends on the type of inflation – if it is a consequence of stronger demand and wage growth then this could have very positive implications for the medium term. If, as currently, it is a result of higher input costs (including energy costs), it has potentially negative repercussions for corporations and individuals.

“One of the reasons that the Bank of Japan is maintaining a starkly different path to other central banks is the belief held by policy officials that current inflationary pressures in Japan will be temporary. We remain cautious but note announcements from Asahi Group Holdings that domestic product prices (beer and non-alcoholic beverages) will be increased between 6% and 10% (the first increase for 14 years) and by convenience store operator Lawson that it will raise the price of its popular fried chicken (“kara-age”) for the first time in 36 years. Backing up these moves are data which shows that input costs (as measured by PPI) are rising at the fastest rate since 1980 while consumer inflation expectations are at 14-year highs.”

James B. Rosenwald, Portfolio Manager of Nippon Active Value, said: “Japan starts from a lower base of inflation but you should also realise that over the past ten years our office rent has not increased and the starting wage for a college graduate remains the same, 2.5 to
3 million yen. This seems staggering in comparison with the US which has seen starting salaries for college graduates nearly double over the same ten-year period. One must also take food prices into consideration and other than imported goods, rice and the staples of the Japanese diet have remained pretty stagnant.

“The one area where consumers are feeling inflation in Japan is their electric bills and the cost of gas. The public is feeling the pain from the rise in these commodities and public opinion is even shifting from a strong anti-nuclear position to one which is open to allowing a turn on of the vast number of nuclear plants that have been mothballed for the past 11 years since the Fukushima tragedy. If the government decides to turn these on, Japan will reap the benefits of building them many years ago and having excess generating capacity, lowering the country’s cost of energy.”

Direction of monetary policy

Taeko Setaishi, Manager of Atlantis Japan Growth, said: “The Bank of Japan having reiterated its policy of keeping 10-year bond yields below 0.25% has helped drive the yen’s decline to a 20-year low against the dollar at a time of rising US Fed rates. This has a negative knock-on impact for Japan in terms of commodity imports, particularly with the jump in energy costs globally. At a time when real wages have risen only marginally the impact on Japanese households will be felt hard. Even though the headline rate of inflation is likely to remain lower than other developed economies, it will be a shock to an economy that has witnessed stubbornly low inflation for over 20 years.”

Joe Bauernfreund, Manager of AVI Japan Opportunity, said: “To the extent that higher commodity prices leads to moderate inflation, it might prove helpful in meeting the Bank of Japan’s so far elusive 2% inflation goal. The lower base, and so far moderate increase, should allow the economy and authorities to respond in a more sustainable and measured way. Furthermore, a weaker yen should help lift inflation and contribute to changing attitudes towards increasing wages. Higher wages are important in sustainably getting the inflation rate above 2%.”

Higher energy prices shifting public opinion

Masaki Taketsume, Portfolio Manager of Schroder Japan Growth, said: “The war in Ukraine has thrown into sharp relief Japan’s dependence on imported energy and its relative lack of energy security. This has also helped to reignite the debate over restarting nuclear power plants which have been idle since the Fukushima earthquake in 2011. While most of the authority for decisions on individual plants actually lies with local governments, there has already been a discernible shift in public opinion and the willingness of central government to engage on the issues.”

Opportunities in automation, small caps and pre-IPO companies

Thomas Patchett, Investment Specialist on the Japanese equities team at Baillie Gifford, said: “Automation is an area that we are particularly excited about. Japanese robotic companies remain global leaders in this field, and are well positioned to benefit from several secular tailwinds, including: technological improvements in dexterity and sensory systems, that are expanding end-market applications; the reorganisation of supply chains, and the shift towards reshoring; and demographic changes within the developed markets, creating the corollary of labour shortages and wage inflation. Shima Seiki – the world’s largest maker of computerised flat knitting machines – is an example of one such beneficiary, that sits at the intersection of multiple themes. Their automated knitting machines enable the fast and efficient manufacturing of garments, enabling shorter supply chains and reduced wastage for the environmentally and socially conscious consumer.”

Kwok Chern-Yeh, Manager of abrdn Japan, said: “Ajinomoto, Japan’s largest producer of seasonings, has a strong sales and product development capability to develop products suited to local tastes. With its high market share in its core business, the company commands pricing power over its customers across the regions where it operates. Outside of foods, the company has expanded into adjacent products such as semiconductor materials and contract development and manufacturing for biopharmaceuticals. These include Ajinomoto Built-up Film, which is the microfilm insulation for electronic devices that has become the industry standard for high-performance central processing units.

Mitsui Fudosan is one of the major real estate developers in Japan, with assets in key locations across the Tokyo metropolitan area. The company stands out in the industry as it has managed to outgrow peers, despite making substantial investments for future growth. With waning concerns about the Covid-19 pandemic, commercial property vacancy rates have bottomed, while retail and hotel assets are poised to recover from the lifting of the quasi state of emergency and reopening of borders.”

Joe Bauernfreund, Manager of AVI Japan Opportunity, said: “We see the most exciting opportunities in Japanese small-caps where there is an abundance of high-quality, undervalued companies. Cash-rich companies are a great source of undervaluation, as the market chronically undervalues balance sheet assets despite improving attitudes towards shareholder returns. One such example is Shin-Etsu Polymer which trades on a 3.4x EV/EBIT multiple with net cash covering 60% of its market cap. We expect it to generate double-digit earnings growth over the next five years. Undervalued opportunities like this arise because of a lack of sell-side research and there are a number of idiosyncratic catalysts to rectify undervaluations including MBOs, improving shareholder returns, private equity takeovers and in the case of Shin-Etsu Polymer, takeovers by parent companies. Shareholder activism, on the rise in Japan, is a powerful force for accelerating change.”

Simon Edelsten, Co-Manager of Mid Wynd International, said: “One consequence of higher inflation is greater investment by manufacturers in productivity. In Mid Wynd International we have around 12% of assets invested in automation companies, which are seeing rising orders. These stocks make up a large portion of the trust’s exposure to Japanese equities.”

Masaki Taketsume, Portfolio Manager of Schroder Japan Growth, said: “Looking within the market, we expect smaller companies in particular to benefit from the domestic re-opening, following a lengthy period of Covid-19 restrictions. Many small caps are exposed to the domestic service sectors where we now anticipate a recovery. Japanese small caps have underperformed larger stocks for the last two years so we see this as an opportunity for them to play catch-up.”

Nicholas Price, Portfolio Manager of Fidelity Japan, said: “I am keeping a close eye on the spike in commodity prices, especially oil, as this will exert a further squeeze on manufacturing margins. On the flip side of that, I am seeing opportunities in companies that supply equipment to the energy sector (beneficiaries of energy diversification in Europe) and are at the bottom of their respective cycles.

“Another area of the market where we continue to see attractive opportunities is in the unlisted sector. There were 125 initial public offerings (IPOs) in 2021, marking the highest number of listings since 2006. Moreover, from a bottom-up perspective, we are seeing a lot more entrepreneurial activity in Japan compared with five to ten years ago. Being on the ground in Japan, and seeing many different companies, means that we are well placed to help entrepreneurs in the latter stages of their pre-IPO journey.”

What is the outlook for Japanese equities over the medium to longer term?

James B. Rosenwald, Portfolio Manager of Nippon Active Value, said: “Given the extraordinarily weak yen and a 30+ year bear market in equities, this is a marvellous time to participate in the Japanese equity market. We could easily see equities providing a 100% return in the next five years.”

Simon Edelsten, Co-Manager of Mid Wynd International, said: “Japanese exporters are seeing their competitiveness improved by the falling yen, though many are held back by weak overseas demand, especially from China. With a longer-term view, China will move past the current Covid issues and the government will stimulate the economy, so 2023 could well prove a good year for Japanese exporters. Also, Japanese car companies have a number of electric vehicle launches planned, so this sector may also recover. It is hard to paint such a rosy picture for more domestically oriented companies.”

Nicholas Weindling, Portfolio Manager of JPMorgan Japanese, said: “Despite some short-term market uncertainties, we are positive about the longer-term outlook for Japan. The corporate governance story continues to develop and this increasingly looks structural in nature. The country is in the process of a major technological transformation that should deliver growth and substantial productivity gains over time. Moreover, Japan’s Prime Minister Fumio Kishida, who was elected in September 2021, remains popular and we expect Japan’s political landscape to remain stable for the foreseeable future.

“Additionally, unlike the case in most other major nations, inflation should not be a significant concern in Japan. Although prices have begun to rise due to rising energy and material costs, there has been no significant increase in property rents, and despite a tight labour market, wage growth remains low. In this environment, rises in energy and other prices may prove to be mostly one-offs, that do not feed through into long-term inflation expectations.”

Taeko Setaishi, Manager of Atlantis Japan Growth, said: “Currently, we see that the stock market still favours value stocks. Growth stocks tend to be out of favour currently due to ongoing uncertainty over geopolitics as well as concerns over possible slowdown in the global economy. That said, however, we are firmly of the opinion that the market will eventually shift towards growth stocks. Although corporates are tending to display conservative forecasts during this results season, we believe that the companies in which we currently invest can exhibit ongoing sales and profit growth, generally have solid market share, and have strong financial track records. The stock market will, we believe, positively assess such dynamics over time.”

Performance and current discounts of investment companies investing in Japan

 Investment company

AIC sector

Total return % (1 yr)

Total return % (3 yrs)

Total return % (5 yrs)

Total return % (10 yrs)


Discount %

Average investment company

 

-2.03

29.77

52.27

209.65

-7.68

Sector average

Japan

-22.68

7.77

33.54

207.56

-8.13

Sector average

Japanese Sm Cos

-27.90

-10.67

23.41

205.25

-5.54

abrdn Japan

Japan

-14.83

15.75

19.04

114.76

-14.97

Baillie Gifford Japan

Japan

-28.07

-2.08

25.01

283.79

-7.91

CC Japan Income & Growth

Japan

3.33

11.22

31.18

-

-9.10

Fidelity Japan Trust

Japan

-26.90

11.39

52.68

203.24

-8.00

JPMorgan Japanese

Japan

-27.20

12.97

45.92

211.52

-5.96

Schroder Japan Growth

Japan

-0.46

14.79

17.22

153.92

-12.29

Atlantis Japan Growth

Japanese Sm Cos

-23.35

-5.74

27.92

144.91

-11.06

AVI Japan Opportunity

Japanese Sm Cos

-2.19

7.61

-

-

-1.35

Baillie Gifford Shin Nippon

Japanese Sm Cos

-37.85

-19.05

18.61

295.79

-3.62

JPMorgan Japan Small Cap Growth & Income

Japanese Sm Cos

-28.72

-0.11

28.68

189.70

-7.81

Nippon Active Value

Japanese Sm Cos

1.64

-

-

-

-10.86

Source: AIC/Morningstar (total return is share price total return, periods to April month-end; discounts at market close on 09/05/22). Japanese Sm Cos = Japanese Smaller Companies.

 

- ENDS -

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Notes to editors:

  1. The Association of Investment Companies (AIC) was founded in 1932 to represent the interests of the investment trust industry – the oldest form of collective investment. Today, the AIC represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and VCTs. The AIC’s members believe that the industry is best served if it is united and speaks with one voice. The AIC’s mission statement is to help members add value for shareholders over the longer term. The AIC has 360 members and the industry has total assets of approximately £268 billion.
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