This blog post is about how economies and the performance of equity markets are related with particular reference to Japan.
The Link Between Economies and Stockmarkets
It is often thought there is a close correlation between how well an economy is doing with the performance of its stockmarket; so if the former does well the latter will as well. A recent example is the US whose economy has been recovering and growing strongly in recent years whilst its equity markets have powered ahead to new highs. The causal factors linking the two are various, including recapitalisation of the banks, significant balance sheet repair at the corporate and personal level, falling unemployment and QE.
The relationship between economies and stockmarkets is however more complex and they may be uncorrelated. For example in the last 10 years China’s growth in GDP year on year, (a measure of the output of an economy) has been strong, albeit there have been declines from the double digit returns. In contrast stockmarket returns were poor on most of this period. Economic growth does not always translate to growth in company earnings. Similarly stockmarkets may rally despite underlying economic malaise. A clear example was in 2009 in the UK. Stockmarkets rallied in anticipation of economic recovery and investors bought equities for future earnings. Finally the corporate sector and stockmarkets may do well despite a flagging economy if overseas earnings are high and exposure to the domestic economy is minimal.
Misunderstanding the correlation between an economy and the prospects for its stockmarket can lead to poor decisions by investors in their asset allocations. For example Japan and Europe with sluggish economic growth, deflation and debt may be regarded as basket cases and avoided by investors. This may prove to be a mistake. Below I comment how this might apply in Japan, Europe is for another blog.
Earlier this week I listened to veteran Japan investor, Chris Taylor who runs the highly successful Neptune Japan Opportunities fund. Like a skilled surgeon he dissected a diseased economy which would have many investors running for the exit. I was unaware just how serious it is. Taylor argued that massive tax receipts are required to avoid national bankruptcy. Yes he used the B word. Japan has a massive problem with a budget deficit and mounting debt. Since 1989 GDP has been flat whilst debt as a percentage of GDP has rocketed. This is due to a collapse of tax revenues and increased spending due to an ageing population. Taylor stated that tax revenues are now at 1987 levels whilst GDP in 2012 was at the 1990 level!
Taylor then went on discuss corporate Japan. This was a very different story. He suggested that Japanese companies have led the way in global corporate earnings since 2008 and this is despite historic Yen strength. To remind you a strong currency makes exports more expensive and historically this has been a headwind for Japanese companies. More recently the Yen has fallen with QE or money printing.
The growth in corporate earnings has come from massive investment outside Japan and developed markets. Companies have shifted from being exporters to becoming global multinationals thereby avoiding Japan’s negative demographics, falling demand and high operating expenses. Overseas subsidiaries have almost doubled in 10 years. This is especially in the manufacturing sector. For example in the auto sector overseas car production has risen significantly since 2007 to 63% in 2013. In addition recent Yen weakness has been a tailwind when overseas earnings are converted back to Yen.
Another factor in favour of Japanese equities that Taylor highlighted was that company earnings are grossly underestimated. Causal factors are conservative projections, failure to account for Yen weakness and crucially too few or experienced analysts. Analysts are the bright young things that support fund managers and investment bankers and undertake important research on company balance sheets, markets and cashflow. These provide vital information that help determine investment decisions. According to Taylor 25% of companies have no analyst cover whilst a further 28% have only one analyst. The implications are clear, Japanese companies may be mis-priced and undiscovered gems can be unearthed by good stockpickers. Moreover active fund management is expected to outperform passive strategies in this market.
Taylor also says valuations are attractive in Japan compared to other markets and Japanese companies have high earnings per share growth. Finally an re-allocation from cash and bonds to equities in the Government Pension Investment Fund (GPIF), the world’s largest is very positive for the Japanese stockmarket.
So what do I conclude? Despite the poor state of the economy of Japan there is a good case for investment in its equity markets.
This blog is intended as a general investment commentary. It is not an invitation to invest in the areas highlighted as these may not be suitable for you. You should seek individual advice before making investment decisions.