Following an explosive re-rating in 2013 that saw the Tokyo Stock Price Index (TOPIX) gain approximately 51% (in local currency terms), we have seen a reversal of Japan’s equity markets so far this year. This has led some investors to question the efficacy of “Abenomics.” With the recent announcement of Prime Minister Shinzo Abe’s revamped growth strategy, Kenichi Amaki, Portfolio Manager at Matthews Asia, believes it’s a good time to reassess the impact of his economic plan, and consider what the future may hold. 

There are literally hundreds of components that comprise Abenomics but one successful area has been job creation. Since it took over at the end of 2012, the Abe administration has created more than 1 million new jobs, with more likely to come given the robust growth in job offers. Discouraged job seekers who had previously left the labor pool have begun to re-enter the workforce. Critics often note that many of these jobs are at the low end of the wage curve in primarily part-time jobs but for the incremental worker and the economy as a whole, a job at a low wage is better than no wage at all. Supported in part by these job gains, corporate earnings have remained robust. The bottom-up picture appears fine as better earnings and share price underperformance have made valuations in Japan that much cheaper.

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Nevertheless, macroeconomic statistics point to some emerging challenges on the horizon, near term. Amaki notes that judgments should not be made based solely on the numbers from the first two quarters of 2014, as they are heavily distorted by the tax hike. However, it still would seem fair to say that the tax hike has dampened consumer sentiment while causing a stiff decline in real household incomes and spending. The major issue behind this is wage growth, which remains muted. Improved corporate earnings have led to wage increases at many larger listed businesses, but smaller and medium-sized enterprises, which employ the vast majority of Japan’s workers, have been more reluctant to raise wages. Wages remain the main hurdle on the path toward sustainable consumption-oriented growth and more concrete steps to address labor regulation must be undertaken.

Meanwhile, over the past year, inflation has turned higher. At the end of 2012, Japan’s consumer price index excluding fresh food—the Bank of Japan’s preferred inflation benchmark—was -0.2%. But by the end of 2013, that had advanced to +1.3%, quite a big change in just 12 months. According to Amaki, this transition to an inflationary environment is slowly starting to change corporate mindsets. In aggregate, Japanese companies have been sitting on piles of cash, which would lose value in real terms in an inflationary world. Share buybacks announced so far in 2014 have already surpassed 2013. We’ve seen companies raise dividends and more have started to set specific dividend payout ratios in lieu of “stable dividends” (i.e. investors get whatever companies feel like paying). 

At the same time, measures to strengthen corporate governance are being put forth By the middle of next year, Prime Minister Abe intends to establish a corporate governance code that will require, amongst other things, stronger oversight by independent directors. Of course, better governance is no guarantee of success but it should, on average, improve the quality of decision-making that goes on inside Japanese board rooms. 

The potential for productivity enhancement induced by better corporate governance is enormous. According to Kenichi Amaki, productivity improvements will be the most important driver of growth for Japan going forward. Currently, productivity of Japan’s manufacturing and non-manufacturing sectors, as measured by output per worker per hour, remains far lower than the U.S., as highlighted in the chart below. Why? Pretty simple: over a decade of deflation caused by oversupply. There are many sectors of Japan Inc. that remain simply too fragmented and companies have little or no pricing power. Such fragmentation causes duplication of capacity and development costs, while keeping competition unnecessarily high, lowering selling prices and profitability.

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In addition to consolidation, the emergence of Internet-based services with disruptive business models can also make an impact on productivity. These new companies don’t carry the legacy costs that plague many incumbent players. Recently, there is evidence that risk-taking is creeping up as Japan’s entrepreneurs attract more capital. Through June, Japanese start-ups attracted 32% more investment from venture capital firms compared to last year. Despite this year’s stagnant markets, investor appetite for new IPOs has remained resilient and venture capital funds seek to seize this opportunity. A government initiative to allow state-owned universities to set up venture capital funds that will invest in the commercialization of innovative research is also being set forth. 

Improving productivity in Japan will involve making many difficult choices. For many years, managers have opted to kick the can down the road. But there isn’t much road left anymore. “These developments have me feeling more optimistic over the prospects for Japanese companies over the medium term”, concludes Amaki.

You may access the full article by Kenichi Amaki, Portfolio Manager at Matthews Asia, through this link.