On February 14, the Bank of Japan broke with tradition and announced an inflation target of 1%.
The yen started weakening, and has lost more than 4% up to yesterday, while the Tokyo stockmarket has soared by around 20%, regaining the 10,000 point for the Nikkei this week.
Nader Naeimi, Senior Investment Strategist & Portfolio at AMP Capital says the move by the central bank is a positive one for Japan and listed companies.
Several failed recoveries, numerous policy mishaps and two decades of poor performance have seen Japanese shares lose appeal as an investment.
Conventional wisdom suggests Japanese shares will continue to be a poor investment over the years to come given weak demographics, terrible growth trajectory and the potential for further policy errors.
This sounds logical.
Japan is unlikely to be a fast growing economy and should continue to see its share of global output decline.
Japanese policymakers made many policy mistakes over the past two decades and there are no guarantees that will not continue.
However this ignores the fact that many of these negatives have to a large degree been priced in.
What has not been priced in is Japanese policy makers finally taking aggressive steps to tackle deflation, the epicentre of Japan’s economic and market woes.
Perhaps the recent move by Japan’s central bank to modify its stance on inflation by vowing to hit a target of 1% year-on-year change in the consumer price index is a start.
The drivers of relative underperformance
Japan saw an end to a robust economic expansion after property and equity bubbles burst in the early 1990s, pushing the financial system and the economy in a downward spiral as authorities struggled to deal with their repercussions.
Japan’s lost decade was a result.
Despite several rebound attempts, Japan’s share market has continued to drift lower ever since.
At first glance it is easy to attribute this poor performance to a weak profit backdrop for Japanese companies.
Dismal demographics, shrinking working age population and a mediocre growth profile add to the conviction that Japanese companies have been and will be suffering from a lack of growth pulse.
Zooming into drivers of Japanese share market performance over the two decades, however, reveals a different story.
While earnings growth did in fact pose a significant drag to the performance of the Japanese share market in the 1990s, the contrary is true over the most recent decade.
This is shown in the graph below which breaks down total return from Japanese shares into contributions from dividends (DY), earnings growth (EPS) and changes in valuation (PE) (i.e. market rating).
The contribution from earnings growth has been nothing less than spectacular over the past decade.
Contrary to popular opinion, Japan’s weak growth backdrop has not impaired the ability of listed companies to generate strong earnings growth.
To a large extent this is attributable to healthy productivity growth in Japan over the past decade.
It also reflects the fact many Japanese firms are becoming less reliant on sluggish domestic demand with sales increasingly sourced from abroad and in particular from the fast growing emerging markets.
While Japan lost its way in the 1990s as real estate and equity bubbles burst, productivity growth has staged a strong comeback since 2000.
Japan’s productivity suffered in the 1990s as a result of failure to deal decisively with the bad loans clogging its banks, which propped up inefficient “zombie” companies rather than forcing them into liquidation.
That meant less capital was available to lend to start-up firms.
Workers’ productivity depends on their skills, the amount of capital invested in helping them to do their jobs and the pace of “innovation” — the process of generating ideas that lead to new products and more efficient business practices.
Over the years Japan has made various efforts at regulatory reform, from freeing up the energy market and mobile telephony in the mid-1990s to liberalising the financial sector in the late 1990s.
These have produced some results.
Japan’s total factor productivity growth began to improve after 2000.
This has filtered into earnings.
Over the past decade the growth in earnings-per-share (EPS) of Japanese listed companies has outpaced nominal GDP growth by an average of 9% per annum.
It appears lacklustre domestic growth and domestic demand conditions have not been the driving force behind Japanese shares’ flagging performance.
More to the point, Japanese shares have suffered from a decade of de-rating.
This has seen long-term price-to-earnings (PE) multiples for the Japanese share market fall to their lowest levels in 30 years.
In other words, Japanese listed companies are trading at their cheapest levels in 30 years.
Indeed even with attractive val
