Productivity gains: the hidden benefit of Japan’s aging population

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It’s been a topsy-turvy year so far for Japanese Prime Minister Shinzo Abe and his cabinet. A number of political scandals saw their approval ratings tumble in July to their lowest since Abe came back to power in 2012. But then the summer recess of the Japanese Diet (parliament) meant less media focus on the alleged political shenanigans, and Abe stepped up to the plate as defender of Japan’s national security in the face of rising tensions with North Korea.

Will Abe’s decision to go to the polls backfire ?

The resulting improvement in ratings for Abe was such that he decided to call a national election in an attempt to strengthen his mandate. With the emergence of Tokyo Governor Koike’s Party of Hope and the impact that this has had on the political landscape in Japan, it is as yet far from certain whether Abe’s gamble will pay off, or whether the outcome of his decision will mirror that of UK Prime Minister Theresa May earlier this year.

Putting politics aside to assess Japanese stocks

What is clear, however, is that we can no longer use the word ‘stability’ when discussing Japanese politics, and we certainly cannot use political stability as a reason for advocating holdings in Japanese equities. However, it does give us an opportunity to reflect on where we stand with this asset class, and look at some of the fundamental reasons for believing the country still deserves attention.

Strong performance of Japanese equities since March 2017

The Topix index has outperformed other developed market indices since the start of the fiscal year, with the Japanese yen, at least against the US dollar, only slightly weakening over the period (Exhibit 1).

Exhibit 1: Recent performance of selected equity indices (31/03/2017 = 100)

gainsSource: Bloomberg, BNP Paribas Asset Management, as of 06/10/2017

Strong corporate earnings

We see the main reason for the index’s performance as being strong corporate earnings growth. Current Nomura forecasts point to 13% YoY growth in recurring profits for the current fiscal year for companies in the Russell Nomura Large Cap Index, which would slightly exceed a 10 percentage point increase on the previous fiscal year[i]. But perhaps even more startling is the large number of corporate earnings revisions in the past few months. Exhibit 2 shows that the revision index has reached levels not seen this decade.

Exhibit 2: Revision index, Russell Nomura Large Cap Index

gainsNote: Revision index calculated by: (no. of estimate increases – no. of estimate reductions) / no. of companies x 100, source: Nomura Equity Research, September 2017

Source: Bloomberg, BNP Paribas Asset Management, as of 06/10/2017

The sectors and segments that have seen the largest improvement include chemicals, cars, electronics & precision, and trading companies. We expect further upside if the yen stays at its current level – the most recent quarterly Bank of Japan Tankan survey[ii] indicated that the USD/JPY exchange rate predicted by large manufacturing companies for the current fiscal year was 109.29.

The yen is currently trading at above this rate, i.e. it is cheaper. We would like to stress, however, that earnings growth has not all been about the yen’s value. Volume growth, cost-cutting and price increases were all cited as factors underpinning (manufacturing sector) earnings growth in the latest quarter[iii].

Valuations – Japan still looks cheap from a geographical perspective

While we believe that valuations are also a reason for a bullish stance on Japanese equities, this is not as clear-cut as it has been in recent years. We have been saying to clients that Japan looks comparatively cheap, from both an historical and a geographical perspective, but now we suspect that only the latter is true.

We use 15x as a ‘rule-of-thumb’ of fair valuations for a forward-looking price-earnings (P/E) ratio using current fiscal year estimates: Topix now is trading at only slightly below that level (14.9x)[iv]. It looks as though stock prices have caught up with the pace of EPS growth, and we can no longer say that the market is cheap from an historical perspective. It does, however, still look cheap from a geographical perspective. Exhibit 3 below shows that both large and small-cap Japanese equities are trading at levels below those of other developed markets.

Exhibit 3: Global index valuations: this fiscal year


Note: PE: price-to-earnings ratio, PBR: price-to-book ratio

Source: Source: Bloomberg, as of 04/10/2017, current fiscal year, using Bloomberg ‘BEST’ estimates

Productivity improvements are another driver

We continue to believe that improvements in corporate governance in Japan can be an important driver for the stock market in coming years. We are not just talking about increases in dividends and shareholder buybacks, which have been happening. We believe that the general change in corporate mind-set that we have seen since the start of Abenomics can lead to a more efficient use of capital, for example, for investment in high growth-potential areas, or to increase productivity.

We think that the latter is particularly important. The most recent OECD Economic Survey of Japan[v] notes that Japan’s labour productivity is around 25% lower than that of the top half of OECD countries, and points to some of the reasons: a widening productivity gap between the manufacturing and non-manufacturing sectors, a lack of economic dynamism at small firms, and the low share of entrepreneurs in the workforce. We see the first of these, shown in Exhibit 4, as the most important and as a reason for optimism.

Exhibit 4: Japan productivity index, 1970 = 100

gainsSource: Bloomberg, BNP Paribas Asset Management, as of 06/10/2017

Our view is that the perceived demographic ‘problem’ in Japan can have a big role to play in improving non-manufacturing sector productivity. Exhibit 5 is a page from an investor conference presentation (although not labelled, the X-axis is the age of their workers, from fresh graduates to retirees).

Exhibit 5: Expenses – human resource planning:

  • Solid cost reduction by optimal stuff allocation
  • Anticipating approx. 3 500 reduction of BTMU’s core officers toward 25 March

gainsSource: MUFG homepage, from BoA Merrill Lynch Japan Conference, Sept 2016. Via Macquarie Securities

The circled ‘bump’ on the graph shows a large number of workers in their fifties, hired in the 1980s. Such employees tend to be the most expensive due to seniority-based pay structures. The left axis of their 2025 projection shows the company’s hiring plans for the next 10 years at around 400 a year: i.e. its idea of an efficient number of workers per age group. It follows that a large portion of current workers in their fifties (the ‘bump’) are considered as an ‘excess’ above this efficient level.

We believe that many non-manufacturing companies in Japan have a similar profile of excess employees, which has led to a lack of incentive to invest (e.g. in IT technology) to change workflows and improve labour productivity. Put another way, they have excess human ‘capital’ that is difficult to let go. This might have even led to companies choosing to diversify into non-core activities to keep these excess workers in employment[vi].

‘Good’ wage inflation on the way ?

So Japan’s demographic ‘problem’, which will see a large number of workers retire over the next 10 years or so, should help companies return to their normal employment levels, releasing capital for investment in better labour productivity and a renewed focus on their core business(es). We are hopeful that this would lead to higher real wages (‘good’ wage inflation), and are pleased that Abe has prioritised labour market reform policy. It just remains to be seen whether he is still in power at the end of the month to push such reforms through.

Written on 06/10/2017

  • [i] Source: Nomura Equity Research, September 2017
  • [ii] Source: Bank of Japan, September 2017 Survey, released on 2 October 2017
  • [iii] Source: Daiwa Securities, October 2017, breakdown of profit boosting factors
  • [iv] Source: Bloomberg, as at 4 October 2017
  • [v] Source: 2017 OECD Economic Survey of Japan, April 2017.
  • [vi] N.B. In our view, foreign competition combined with operating overseas has forced Japan’s manufacturing sector into productivity improvements, which is not the case in non-manufacturing (and generally domestically focused) sectors.
Tony Glover

Director & Head of Investment Management Department, Japan Office, CFA, CAIA

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