Postcard from Japan

– Alasdair McKinnon looks at the history lessons to be drawn from Japan

I recently returned from a round of company visits in Japan. The country is always a fascinating mix of the familiar and the strange, the innovative and the traditional. It’s also a fascinating case study for contrarian investors. Japan’s recent economic history illustrates just how dramatically things can change – and how surprised most people are when they do.

Japan was the envy of the world

Just over 30 years ago, Japan was the world’s largest equity market, accounting for around half of global market capitalisation. Its business practices were regarded with awe, and investors couldn’t get enough of its stocks. Japan was the future.

But Japan’s rise was a direct result of its ruinous state after the Second World War. People, Japan’s key resource, were prepared to work for next to nothing, and a weak yen rendered their products remarkably cheap. The US eventually found itself running a huge trade deficit and struggling to compete with Japanese goods. Meanwhile, Japan’s living standards rose rapidly, and it shifted from aping Western products to surpassing them. ‘Made in Japan’ was once synonymous with poor quality but came to be a mark of high-end goods

Japan’s boom and bust

Ultimately, US displeasure led to the Plaza Accord in 1985, with the largest Western economies and Japan intervening in the currency markets to weaken the US dollar. The yen rocketed higher – and people assumed that it would sustain its upward trajectory forever. The money that flooded into Japanese assets created a bubble of prodigious proportions in the equity and property markets. To make matters worse, the central bank sat on its hands, further exacerbating booming asset valuations.

Although the bubble eventually burst in 1990, Japanese society couldn’t stomach the appropriate correction – otherwise, the banks and companies that had loaded up with debt would have collapsed. In a society in which a job for life was the norm, this was unacceptable. Interest rates were slashed to near zero, and Japan lurched on with zombie companies only kept alive by zombie banks. One result of this was that the population started saving more and spending less, plunging the country into a deflationary spiral.

This was the country’s ‘lost decade’, in which the economy failed to grow and the stock market languished. Some observers note that it was really two lost decades, as the economy remained subdued through the 2000s.

A consequence of the era of economic gloom is that the birth rate has fallen. Japan now has a lower fertility rate than China – despite the latter having only recently abandoned its one-child policy. This has profound implications on Japan’s population which is set to decline by more than 5%, and its workforce by a full 18%, by 2030.

Lessons to be learned

As Mark Twain is reputed to have said, “history doesn’t repeat itself but it often rhymes”. Japan’s recent history offers parallels with Western economies today. The rest of the world has enjoyed an asset boom, which, some might argue, relies heavily on debt taken out at historically low interest rates. Confidence is high that any imbalances can be corrected by central-bank sleight of hand, but Japan has shown that this may not be as easy as assumed.

Since 2012, Shinzo Abe’s government has taken drastic steps to turn Japan’s economic prospects around, devaluing the currency and attempting to erode the country’s debt burden by creating inflation. ‘Abenomics’ has succeeded in reigniting the economy, but inflation has so far proved elusive.

Is there any reason to believe that other central banks will be more successful than the Bank of Japan in creating the inflation required to level the debt mountain? If not, then Japan’s past and present may offer a depressing roadmap for the West. Perhaps they will react more timeously.

It’s possible, however, that Japan will manage to escape the deflation trap. Japan’s policymakers have shown commitment towards that goal and the electorate have backed them. Should Abenomics succeed, the benefits for Japanese shares could be extraordinary. At the moment, investors appear to have largely written off this prospect. That’s a signal for contrarians like us to look more closely.

Contrarian opportunities

So where are the contrarian opportunities in Japan? At present, we are particularly positive about the potential for improvement in Japan’s banks. Once the world’s biggest, these all but went bust in the early 1990s. But they have now been solvent for 15 years and came through the 2008 financial crisis relatively unscathed. With Japan’s negative interest rates, they effectively have more money than they know what to do with. A catalyst may be required for this to be put to the service of shareholders, but there’s considerable potential for lucrative returns. We hold both Sumitomo Mitsui Financial Group and Bank of Kyoto – stocks that most investors have given up on.

Nor should we forget Japan’s capacity for innovation. In recent years, we’ve done very well from our holdings Nintendo and Sony. Nintendo suffered losses as earnings matured for its older gaming devices but the company has continued to excite consumers with the successful launch of its Switch console. For Sony, the company has restructured loss-making businesses and returned to profitability amid rising demand for its leading-edge image sensors and games consoles. With their global reach and long record of innovation, these companies delivered regardless of the outcomes in the domestic economy.

Things don’t stay the same

In the years ahead, we’ll gain greater clarity on whether Western countries are following in Japan’s painful footsteps and on the ultimate success of Abenomics. But when we consider Japan’s zigzag path from post-war ruin to global leadership to deflationary stagnation, the one lesson we should draw is that things don’t stay the same. As contrarian investors, we must always strive to expect the unexpected – and position our portfolio accordingly.

Please remember that past performance may not be repeated and is not a guide for future performance. The value of shares and the income from them can go down as well as up as a result of market and currency fluctuations. You may not get back the amount you invest.

Please note that SIT Savings Ltd is not authorised to provide advice to individual investors and nothing in this promotion should be considered to be or relied upon as constituting investment advice. If you are unsure about the suitability of an investment, you should contact your financial advisor.