Effectiveness of Japan's Abenomics up for debate

Japanese Prime Minister Shinzo Abe, centre, poses for a group photo with members of Japanese pop group Momoriro Clover Z and Japanese child actors wearing Japanese kimono during a cherry blossom viewing party hosted by Abe at Shinjuku Gyoen National Garden in Tokyo on Saturday

TOUTED by many as Japan's last chance to maintain relevance as a major economic power, Abenomics was intended as a bold mix of monetary easing, fiscal stimulus and structural reforms designed to revitalise the world's third largest economy.

Yet despite all the hype it garnered among investors, its actual effectiveness is still subject to debate. On one hand, there are signs that Japan is finally beginning to escape from deflation.

Meanwhile, evidence of structural change has started to emerge, with Japan's recent signing of the Trans-Pacific Partnership (TPP) trade agreement and rising female labour participation in the labour force. On the other hand, the further structural reforms needed to open up what is still a relatively closed economy remain so far notably absent.

The reaction of equity markets to all this has been less nuanced. Since the launch of Abenomics in 2013, Japanese equities have soared by nearly 50 per cent even including this year's dramatic pull-back.

The world's market strategists and economists tend to see this pull-back as an opportunity to buy a market that is optically one of the most inexpensively rated out there. We explore some of the arguments for and against Japanese equities below.

On paper, there are several convincing reasons to recommend an overweight position on Japan. For starters, earnings growth expectations for Japanese equities are clearly sunnier versus other developed markets. The fact that these brighter earnings prospects are seemingly valued so parsimoniously by investors relative to the historical average surely adds to the market's lustre.

Meanwhile, much fanfare has been made about the implementation of corporate governance reforms designed to improve shareholder returns. Japan Inc is notorious for hoarding cash on its balance sheets relative to developed markets. By focusing on shareholder returns, these corporate governance reforms should, in theory, help unlock these cash piles, forcing higher dividend payouts, while also increasing return on equity (ROE).

However, closer inspection reveals some flaws in this reasoning. While Japanese earnings growth expectations are indeed outpacing other developed markets, the analysts in charge of formulating such expectations have historically been the worst offenders in terms of excessive optimism.

The fact that sales growth expectations are trending in the opposite direction should peak our suspicion further yet. Japanese equities may still look inexpensive relative to their historical P/E average. However, as is often the case, history may be giving us a misleading signal - the MSCI Japan spiked to a trend distorting high of 30 times earnings in mid-2009 for example.

In the end, much rests on one's view of the trajectory of corporate profitability in Japan. If you believe that the pick-up in ROE seen since Abenomics landed is durable, then sustainably higher price to book and earnings multiples may well be warranted.

However, arguments that the surge in ROE and dividend payments can be attributed to relatively minor corporate governance reforms seen so far look thin. For one, such reforms will likely take more than a few quarters to bear fruit.

But also, the uptrend in dividends and ROE for Japanese companies actually began before these reforms were introduced suggesting that the causal link between Abe's reforms and profitability is potentially tenuous.

While there seems to be a positive consensus on Japanese equities, a closer examination of the data reveals a far more nuanced and subjective picture. As of now, the data does not warrant us altering our broadly neutral stance. It will take much bolder structural reforms and a more sustainable uptrend in ROE before that stance gets reviewed.

Nevertheless, some exposure to the Japanese corporate sector is warranted for investors from a diversification perspective alone. If pressed, our model yields an indicative value of around 1350 for the TOPIX this year, suggesting moderate further upside from here.


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