Japanese Equities: Has the Third Arrow Fallen Short? by Katsuaki Ogata, AllianceBernstein
Japanese prime minister Shinzo Abe’s latest blueprint for sustained long-term economic growth was met with quite a bit of skepticism. It’s easy to play down the so-called Third Arrow as an assortment of cryptic reform measures. But we believe that there’s some substance that warrants equity investors’ attention.
Cynicism toward the plan unveiled in June hasn’t been as harsh as a year ago. The initial growth strategy last year was more skeletal and paled in comparison with the Bank of Japan’s stunning monetary easing (the First Arrow) and the massive fiscal stimulus (the Second Arrow) that was announced just months earlier. Still, a Financial Times columnist opined that the latest measures amounted to a “thousand trial needles” rather than a “Third Arrow.”
But what does it mean for the equity market? It’s true that, on a macroeconomic level, there’s a lot of uncertainty and it will take time for many of the measures to gain traction. Yet, as far as corporate behavior is concerned, we believe that there is a higher degree of certainty about its impact, and changes may happen more quickly than the market appears to expect.
There are two reasons behind our conviction. First, the measures to improve the underlying profitability of Japanese companies are strategically aligned to affect businesses at various levels (Display). Second, there are reasons to believe that Japanese companies would not want to fall behind their peers on the reforms.
Concerted Effort to Boost Profitability
On the first point, the first group of initiatives puts pressure on investors to seek higher profitability from Japanese companies. These include three important measures:
- The introduction of the JPX-Nikkei Index 400, a stock index focused on companies with higher return on equity (ROE)
- A revision to the asset allocation of the ¥126 trillion GPIF (Government Pension Investment Fund) which places more emphasis on high-ROE companies
- The launch of a Stewardship Code to promote stronger engagement between businesses and institutional investors
The second group of initiatives puts pressure on companies themselves, such as the Industrial Competitiveness Enhancement Act, which aims to correct over-regulation, underinvestment and delays in industry consolidation. A revision to the Corporate Law in June and a corporate governance proposal by ruling Liberal Democratic Party lawmakers both aim to make management more accountable. The third group, which includes a reduction in the corporate tax rate, would affect ROE more directly.
Such a concerted effort has been rarely seen before. A recent pickup in share buybacks, M&A and board restructuring may be a sign that Japanese companies are starting to respond.
Following the Leader
In June, a government advisory panel issued an interim report called the “Ito Review”—similar to the 2012 Kay Review in the UK. Looking into the structural reasons for the low ROE and low growth of Japanese companies, the panel blamed dismal profit/sales margins, which were uniformly low in Japan compared with those in other countries. We believe that there are cultural reasons for this uniformity, which leads us to expect that once major companies shift to higher-margin business models, others will not want to be left behind. To that end, the long-anticipated end to deflation should help companies regain pricing power and rebuild profit margins.
Higher ROE tends to be associated with higher valuations (Display, left). Considering that the improvement in Japanese companies’ ROE since the global financial crisis has been underappreciated (Display, right), we believe that there is plenty of room for valuations to shift higher. And if investors—domestic and foreign—begin to recognize the changes underway, there is a good chance that Japanese equity valuations will be re-rated.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Katsuaki Ogata is Chief Investment Officer of Japan Value Equities and Takuji Oya is Senior Portfolio Manager, both at AllianceBernstein Holding LP (NYSE:AB)