First Eagle - Japan Commentary
On December 26, 2012, Shinzo Abe was elected Prime Minister of Japan for the second time. His election platform consisted of monetary, fiscal, and trade-friendly measures to restore Japan's economy to a growth track. In reaction to his election, the yen has declined dramatically while generally stock prices have risen strongly.
The appointment of Haruhiko Kuroda as central bank governor in March of 2013 is perhaps the most controversial of these measures to date. Later confirmed by parliament, Kuroda quickly announced highly unusual and aggressive programs in an effort to reach the government's goal of 2% inflation. These programs include a doubling of the monetary base, an expansion of the government bond purchase program to include longer-term maturities and the purchase of Japanese equity ETFs and REITs. While the immediate effect of these policy announcements has been a weakening of the yen exchange rate, the outright purchase of ETFs and REITs is meant to inflate asset prices and, by effect, induce spending by households (the so-called "wealth effect"), very similar to the asset support policies in place in the United States. While First Eagle's investment approach is bottom-up by nature, we do find significance in certain macro changes. The potential monetary, fiscal and political changes in Japan certainly qualify.
In the first quarter of 2013, the yen weakened against the dollar by 8.6%.1 This has been the major factor driving the sharp increase in the share prices of Japan's export-oriented companies. As of March 31st, this type of company makes up roughly half of the Japanese exposure in the First Eagle Global and Overseas Funds. Partially offsetting the gains, however, has been the decline in the yen exchange rate. In fact, although the Topix Index rose 21% in 2013's first quarter, the U.S. dollar gain amounted to 11%.2
Despite the steep increases in share prices, based on book value, the market may still appear cheap. Half of all Japanese stocks trade below book value. This is comparable to Greece. In the United States, only 12% of companies trade at such a low figure.3
It is important to note that based on this metric current valuations may be justified. With decades of low interest rates, low growth and lack of reinvestment opportunities, generally Japanese companies often have very low returns-on-equity and heavily over-capitalized balance sheets.
Furthermore, despite the sudden shift in sentiment towards Japan, challenges remain. For example, net government debt is very high, at over 130% of GDP.4 This debt is serviceable only because interest rates in Japan remain very low due to the ability of the Japanese government to finance itself through domestic savings. Importantly, questions have arisen recently as to the sustainability of internally financed Japanese deficits.
The population is also aging with almost a quarter of the population over the age of 65. This is among the world's highest percentage of aging citizens and double the proportion 20 years ago. This demographic trend, unless rebalanced by birth rate or immigration, will mean that the population would be 25% smaller by 2050,5 implying serious headwinds for growth.
Finally, and some assume partly due to demographics, deflation has been a systemic condition for most of the past decade. As much of the population is aging, and likely benefits from static prices, it is still questionable whether policy shifts to encourage price increases will be tolerated by the voting masses in the long term.
There are very strong headwinds facing Japan's economy and its equity markets over time. Although aggressive monetary action has clearly succeeded in raising asset prices in the short term, long term sustainability of these positive trends likely requires a wellrounded approach, that includes market-friendly fiscal and trade policy shifts – and, of course, a willing population.
So, if Japan can sustain its policy shift, if the authorities follow through on growth-friendly fiscal and trade policies, and if the population can withstand the initial shock of price increases, then perhaps business values can grow, investors will return and one of the most impressive bear markets in recent history might end.
At First Eagle, we do not attempt to predict the future. Our focus continues to be seeking to identify quality businesses priced at what we believe to be a discount to their intrinsic values. We are global, bottom-up value investors and do not make decisions based solely on a macro view about a particular geography. Nonetheless, a notable portion of our Global and Overseas Funds' holdings are located in Japan and the fundamentals of these businesses may be influenced by the significant changes underway in Japan. As a result, we wanted to share our thoughts about the current economic environment in the country.
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The commentary represents the opinion of Abhay Deshpande as of May 2013 and is subject to change based on market and other conditions. The opinions expressed are not necessarily those of the firm.These materials are provided for informational purpose only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.The views expressed herein may change at any time subsequent to the date of issue hereof.The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy or sell any fund or security.
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