The following is an adaptation of our recent commentary, “2H 2023 Global Equity Team Outlook: Japan, Global AI and an Uneven Covid Reopening” (Read the commentary in its entirety here.)
After an extended period of underperformance, the Japanese equity market has quietly emerged as one of the strongest over the past year. Japan has long been viewed as attractive from a valuation perspective, but we haven’t seen the catalysts that could unlock and sustain this valuation opportunity … until recently.
Catalyst 1: The TSE is influencing capital allocation policies in a shareholder-favorable way. We’re seeing new momentum driven by the Tokyo Stock Exchange (TSE) and its CEO Hiromi Yamaji focused on improving governance, transparency, and ultimately the valuation of Japanese equities. The TSE’s efforts carry significantly more weight and would require companies to delist if they fail to achieve or show meaningful progress toward required capital efficiency targets before March 2026. Our conversations with company management teams indicate that they are responding swiftly. We’re encouraged to be hearing about improved corporate governance, transparency and independent oversight, as well as streamlined reporting structures and business segments, rationalized non-core assets, and increased share buy-backs and progress in capital allocation plans.
Catalyst 2: A shift in business and consumer mindsets amid signs of waning deflation. Japan’s economy also benefits from an improving fundamental outlook. While most countries are concerned with elevated levels of inflation post-Covid, Japan is embracing its newfound inflation. And there’s reason to believe that higher inflation may endure: Wages are increasing in Japan at a more significant rate than we’ve seen in recent history, and women’s workforce participation has reached an all-time high, which is bolstering consumption.
Market reform, reflation, and reopening tailwinds should continue to support better Japanese equity performance in the upcoming years. We hold a combination of high-quality multinationals that we believe are some of the better companies globally but have historically traded at a “Japan-market” discount. We also maintain positions in companies more directly exposed to the post-Covid reopening and to companies whose balance sheets and valuations make them more likely to enjoy a boost from market reforms or reflation.
Covid reopening and the different speeds at which it is occurring around the world are important factors in our outlook for the second half of 2023 and beyond. The US was quick to reopen compared to many parts of Asia, including China. This speed, combined with stimulus checks, resulted in a quick V-shaped consumer spending recovery. Many Asian countries that reopened before China have experienced strong recoveries in consumer spending, especially travel and entertainment. In contrast, China was one of the last countries to end lockdowns, which leaves its recovery a few years behind the US and with negative impacts that will likely take longer to unwind.
There are many reasons that China’s recovery has been uneven and slower than in the US or other parts of Asia. Among them, wealthier individuals who were less affected by lockdowns have returned quickly to spending on luxury goods, travel, and gambling, providing a boost to areas like domestic tourism. However, the average Chinese consumer may take longer to recover from the pandemic given there wasn’t stimulus money to spend when the economy reopened. We believe the Chinese recovery will likely remain bifurcated near term, but consumer spending will recover over time.
A central component of our process is identifying and investing alongside global secular growth themes. Typically, these themes are found in areas undergoing transformative innovation and disruption, and in some instances, can run for decades. Advancements in artificial intelligence (AI) and large language models (LLM) like ChatGPT are a great example of the evolving and durable nature of a growth theme, in this case intersecting themes like increasing mobility and connectivity, mass digitization and data, and artificial intelligence.
The rise of AI is driving a race to build computing infrastructure to support further advances and mass usage. We are at the early stages of what looks to be a transformational shift, but it stands on the shoulders of advancements in computing power that have been powering a variety of other themes for more than a decade (Figure 1).
Source: Stanford AI Index, Evercore ISI Research.
Indeed, the semiconductor industry of the digital age is analogous to the pickaxe and shovel suppliers of the gold rush. And while the world is only beginning to understand the productivity-enhancing potential of generative AI for consumers and businesses, significant capital spending to build the infrastructure to train and use these huge models is already underway (Figure 2).
Source: BofA Global Research, “Me, Myself and AI-Artificial Intelligence Primer,” February 28, 2023
In the near term, we believe the opportunity lies with many of the companies leading computing advancements over the last decade. And that is a truly global group.
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