Dear Shareholder
Global markets performed well in the six months ended April 30, 2019, the first half of your fund’s fiscal year. The gains were broad-based, with nearly all developed and emerging markets recording positive returns. The U.S. dollar was mixed against major currencies during the period, helping insulate U.S. investors from last year’s headwind of falling currency-adjusted returns.
Such an outcome was hardly clear at the start of the period, when many global stock indexes tumbled briefly into bear market territory. In the U.S., investors initially seemed concerned about rising U.S. interest rates, with the Federal Reserve ostensibly on course to keep raising the federal funds rate through 2019. Worries soon shifted to an economic slowdown, as disappointing data accumulated on housing, manufacturing, business investment, and consumer spending.
Signs of weakness in European and Asian economies were even starker. The contraction in the massive Chinese manufacturing sector, often viewed as a barometer of global demand, was especially worrisome in light of the ongoing U.S.-China trade dispute. The export-focused economies of Japan and Germany also struggled as businesses cut back investment in anticipation of new trade barriers.
Political concerns weighed on sentiment as well. In Europe, the new populist Italian government appeared to be headed for a standoff with the European Union (EU) over Italy’s rising fiscal deficit, uncertainty over Brexit continued, and the French government sought to quell its own populist uprising in the form of the “yellow vest” protests. In the U.S., the partial government shutdown was seen as another threat to growth as it wore on.
The turnaround that began around the new year stemmed from improvements on many of these fronts. Most important, perhaps, was a pivot in Fed policy. In early January, Fed Chair Jerome Powell offered assurances that the central bank was prepared to counter any slowdown in the U.S. economy, and policymakers soon signaled that they did not expect any further rate increases in 2019. By April, many investors had even come to expect the Fed’s next move to be a rate cut.
The global economic picture also brightened somewhat. U.S. consumer spending picked up after the government shutdown ended in late January, and the job market remained strong. Signs that the Chinese economy was responding to new government stimulus emerged in April, and rising oil prices suggested healthy global demand.
Europe remained the outlier, with growth continuing to stall in the core economies of France and Germany. In response, the European Central Bank announced that it would keep short-term interest rates near 0% through at least year-end, while also providing a new round of subsidized loans to banks to spur credit growth. Some calming in the region’s political turbulence also helped restore confidence, particularly after the EU granted the UK a prolonged extension to come up with a revised Brexit plan.
Growing hopes for a resolution to the U.S.-China trade dispute further boosted global sentiment. In January, President Donald Trump declared that he was pleased with the progress in the negotiations, and he later canceled a March deadline for reaching a deal. In April, global markets rose after the president declared that an “epic” deal was near, and reports surfaced that an agreement might be signed as early as May.
As of this writing, no trade deal has been inked, and markets have again become volatile as the two sides seem to be hardening their positions once again. I have no special insight into whether an agreement will be reached, but a deepening of the conflict into an all-out trade war would surely be negative for markets.
That said, I am encouraged by much of the feedback I am getting from our managers, analysts, and economists, who continue to see considerable potential in pockets of the global economy. Within Asia, for example, our team in Hong Kong sees opportunities in the Chinese auto and property markets, while our Tokyo team thinks changes in Japan’s corporate governance will continue to benefit investors.
We think our emphasis on collaboration across offices and investment teams helps improve results for all our shareholders, and your fund’s manager is a key part of that process. I am confident that our combined efforts will continue to help you achieve your long-term investment goals.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
Group Chief Investment Officer
Management’s Discussion of Fund Performance
INVESTMENT OBJECTIVE
The fund seeks long-term growth of capital through investments in common stocks of companies located (or with primary operations) in Japan.
FUND COMMENTARY
How did the fund perform in the past six months?
The Japan Fund returned 4.59% in the six-month period ended April 30, 2019. As shown in the Performance Comparison table, the fund outperformed its TOPIX Index benchmark and the Lipper Japanese Funds Average. (Returns for I Class shares varied slightly, reflecting its differing fee structure. Past performance cannot guarantee future results.)
What factors influenced the fund’s performance?
The fund performed strongly against a backdrop of structural reform and improvement in corporate earnings. This was despite a weak December, which saw global growth concerns lead to a brutal re-pricing of Japanese equities. Within cyclicals (including our favored recruitment stocks), IT and higher-quality China-exposed exporters experienced extreme selling, making for a challenging period for stock selection and fund performance. However, 2019 looks set to be a record year for buybacks, while shareholder activism is picking up, both of which have supported investor sentiment.
On a sector level, the largest contribution to relative returns in the last six months came from owning IT and services companies and avoiding banks. Conversely, stock selection among automobiles and transportation companies detracted.
In the IT and services sector, the biggest contributor to relative performance was GMO Payment Gateway (TSE:3769, Financial). The online payment processing company enjoys a dominant position in Japan and stands to benefit from the move to digital payments. The company generated strong first-quarter operating profit growth and benefited from its joint efforts with Sumitomo Mitsui Financial Group and Visa on cashless payments. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
Elsewhere in the sector, an overweight holding in Benefit One helped relative returns. The human resources services provider has delivered accelerating topline growth, while structural and legal changes facing the labor market are providing a tailwind.
Having no exposure to banks also provided a strong contribution to relative performance. Bank margins are subdued due to low interest rates, and loan growth is depressed given too much competition and sluggish demand. Intense competition means that there is an almost unlimited supply of loans at very low rates. Demand is improving for these loans, but they are being offered with interest rates that are comparable to those of Japanese government bonds (i.e., around 0%) in some instances. Net interest margin compression is easing, but some banks are sacrificing this as they try to gain market share.
In the financials excluding banks sector, overweight exposure to Aruhi benefited relative returns. The brokerage company continues to gain share in the housing loan market.
Stock selection and an underweight position in automobiles and transportation equipment detracted from relative performance. Suzuki Motor reported falling sales in India and announced that it was cutting production. Our overweight in Nippon Seiki also hurt returns, as the company struggled to grow volumes in automobile and motorcycle parts.
How is the fund positioned?
The IT and services segment remains that fund’s largest industry allocation, roughly twice that of the benchmark. We have a particular focus on staffing services, where Japan’s aging workforce and tight labor market should result in higher wages and staff turnover. We also have a significant overweight in machinery, where Japan has many leading companies that are expanding globally. We have smaller overweights in retail trade and foods.
Conversely, we ended April with no exposure to the banking sector, which represented over 6% of the Topix Index. We are also significantly underweight transportation and logistics, as well as commercial and wholesale trade, as we are finding more attractive investment opportunities elsewhere.
We prefer investments where we see the potential for margin improvement, robust earnings growth, and an attractive dividend yield. In addition, we are also investing in companies that we believe stand to benefit from structural changes in Japan’s economy, such as the shift to digital payments, changing consumer preferences, the aging population, and the tightening labor market. The majority of the changes to the portfolio continued to be the result of stock-specific investment themes, rather than a reflection of a shift in our sector views.
We added to our holding in Takeda Pharmaceutical (TAK, Financial), partly funded by trimming our exposure to Chugai Pharmaceutical (TSE:4519, Financial). Takeda Pharmaceutical operates globally, with key therapeutic categories in gastrointestinal, oncology, and central nervous system. Its recent acquisition of Shire is a transformational deal for the company, allowing it to move from a domestic to a truly global player. We believe that the synergies from the deal will be significant and are underappreciated by the market. We trimmed Chugai Pharmaceutical as we believe the stock price reflects many positives regarding its hemophilia drug, and the risk/reward trade-off is less attractive at these levels.
We reduced our overweight in the IT and services sector by scaling back our holding in Benefit One (TSE:2412, Financial), one of Japan’s leading providers of employee benefit services. The stock has been the best-performing HR-service sector name over the past several years, and we trimmed our holding as the valuation rose. While topline growth should accelerate, the pace of margin expansion is likely to slow now that the core business enjoys operating profit margins of close to 35%.
We also sold some shares of Hikari Tsushin (TSE:9435, Financial), which distributes office equipment to small businesses and resells mobile phone contracts to both individuals and small businesses. The stock has performed well, and we believe the risk/reward trade-off has become less attractive.
What is portfolio management’s outlook?
We believe that the valuation case for Japan still holds and that corporate earnings are likely to grow faster in Japan than in the rest of the world. Nevertheless, the condition of the global economy remains a critical factor for the Japanese equity market. On this point, our view is that we remain in an environment of fairly robust global growth, which should help the best of corporate Japan perform reasonably well. However, we have become somewhat concerned about the escalation of the trade war rhetoric that is coming from Japan’s largest trading partners. We hope that sanctions and trade war concerns will subside, but the quality bias within the portfolio should hold us in good stead if trade wars jeopardize the supportive growth environment.
Increasing stock-specific dispersion will need to be navigated in the near term as the market digests subtle changes in the top-down investment case and reacts to surprise and disappointment always inherent in Japan. Over the medium term, we remain upbeat, especially regarding those stocks central to Japan’s evolution, and believe that investing in durable and improving businesses capable of weathering economic turbulence remains the best approach to investing in Japan.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
