As we’ve discussed in recent posts, our investment process marries fundamental research with the identification of long-term secular growth themes, such as those related to demographics and consumption. Based on an intersection of bottom-up and top-down criteria, we’ve become increasingly constructive on Japan’s equity market over recent months. We anticipated that the Bank of Japan (BOJ) would provide additional accommodative monetary policy and that Japan’s Government Pension Investment Fund (GPIF) would continue to increase allocations to local equities.
So, we’re well positioned in light of recent announcements from the BOJ and GPIF. Last week, the BOJ made a surprise announcement that it would increase its monetary target by ¥80 trillion and also purchase stock assets. Previously, the central bank said it planned to increase Japan’s monetary base by ¥60-70 trillion yen annually.
Also significant was the BOJ’s statement that it would consider buying exchange traded funds that track the Nikkei 400 Index. Introduced in January, the index includes companies that meet certain standards of profitability, including higher return on equity (ROE), as well as shareholder-friendly corporate governance policies.
Prime Minister Shinzo Abe’s government has spotlighted the index as a key part of its structural reforms. And by putting its own stamp of endorsement on the index, the BOJ is tacitly moving into economic areas well beyond traditional monetary policy, while also demonstrating its alignment with Prime Minister Abe’s initiatives. A company that generates strong free cash flow but decides to sit on its cash will see a negative impact to ROE and risk not being incorporated in this now-important index. This should promote higher dividends, buybacks, and/or capex spending—all positive for equity markets and potentially for Japan’s economy as well.
Additionally, last week, Japan’s Government Pension Investment Fund (GPIF) announced a new target asset mix last week. GPIF manages the pension assets for Japanese public sector employees. As one of the largest pension funds in the world, shifts in its allocation can have a meaningful impact on the markets. There were several positives in the announcement, including:
- The allocation to Japanese stocks has risen to 25% from 12% (with a permissible range of deviation of nine percentage points). To accommodate this increase to local equities, the allocation to bonds has dropped from 60% to 35% (permissible deviation of 10 percentage points).
- The allocation to non-Japanese equities has also doubled, which we believe can provide a boost to the global equity markets.
- The benchmark for the international (non-Japan) stock portion of the GPIF has changed from the MSCI World ex-Japan Index to the MSCI All Country World Index ex-Japan. As a result, the benefits of the increased international allocation target may be especially pronounced for emerging market assets because the new index incorporates emerging markets, while the previous one did not.
Current valuations are reasonable, and we see additional room for P/E expansion. The one-year forward P/E of the Japanese equity market, as measured by the Topix 400 Index, is currently at 15x. While this is higher than the 12x level of October 2012, it is far less than the 20x multiple reached in April of 2013. As GPIF implements these new targets (which may take a period of years), we expect that it will take advantage of price weakness, providing added support to the global equity markets.
We’ve been building our allocations through new purchases and by increasing allocations to existing holdings. We’re favoring export-oriented companies and companies that are positioned to benefit from asset reflation. We’re still relatively more cautious on companies tied to the Japanese consumer, given the headwinds of a weaker yen and increasing taxes. The prospects of these stocks would be more compelling if the government postpones the next value-added-tax increase or if valuations come down some more, but last week’s announcements by the BOJ and GPIF likely increases the chance the VAT proceeds as previously expected.
As we have added to our Japanese equity allocations, we have maintained our focus on risk management. For example, we’re closely monitoring our yen exposure to ensure it does not exceed the levels with which we are comfortable.