Alfred Lee, of BMO Global Asset Management, lays out factors that are making Japan more appealing to institutional investors
With inflation figures running to multi-decade highs on both sides of the Atlantic, investors might believe runaway price increases are an all-encompassing problem. But one member of the G7 group of countries has bucked the trend.
“Inflation has historically been low in Japan. But we were still very surprised that even with all the global inflation that we're seeing, Japan didn't really get caught up in all this,” says Alfred Lee, portfolio manager at BMO Global Asset Management.
According to data from the Organisation for Economic Co-operation and Development, average annual inflation across all G7 countries for the month of February was 7.7%; that includes 7.9% for the U.S., 5.7% in Canada, and 3.6% in France. But in Japan, inflation measured for that month was a relatively modest 0.9%.
One major reason behind Japan’s inflation resistance, Lee says, is the country’s much older population. Thanks to its aging demographic as well as its more conservative culture, the country has not been as consumption-based as North America or even Europe. That disparity is reflected in Japan’s national savings rate, 27% of GDP, compared to 18% in the U.S. and 20% in Europe.
“The population in Japan has been shrinking as well,” Lee adds. “Generally, inflation happens when you have an increasing number of people chasing a more limited amount of resources and goods. But in Japan, it’s almost the opposite scenario – fewer and fewer people chasing the same amount of goods.”
Japan’s manufacturing-based economy, with a focus on electronics and vehicles, has also contributed to the low-inflation trend.
Beyond that, Lee pointed to the country’s low wage inflation: wages have been relatively flat for the past 10 to 20 years, he says, in part because of companies not wanting to poach talent from other firms. In stark contrast to the cutthroat competition in North America, Japan’s corporate culture is one of extreme loyalty where it’s not unusual for someone to begin and end their career at the same company.
Lee estimates that over the past 10 years, investors have tended to avoid Japan because of its low inflation rate, which has even crept into deflation territory at times. But after an unprecedented release of fiscal and monetary stimulus, many countries are now facing decades-high inflation, and more and more central banks are suddenly moving toward tighter monetary policy.
“Both the Bank of Canada and the Federal Reserve already started raising rates at their March meetings,” Lee says. “The market is pricing in eight rate hikes for the remainder of the year from both central banks, but there’s only six meetings left. Still, the fact that we’ll be seeing higher interest rates, which typically aren’t good for equity markets, presents a little bit of a headwind for North America and many other countries.”
Because the onus for Japan’s central bank to fight inflation isn’t as high, it represents a relative safe haven for equity market investors compared to other places where the monetary policy environment won’t be as hospitable. Aside from that, Lee says the Japanese equity market has underperformed global markets since March 2020, which for many investors means Japan’s stock market is undervalued and due for some mean reversion.
“When you look at the market valuations, it's cheaper,” he says. “The PE ratio of Japan’s stock index is 13.7 times, compared to the S&P 500 which is 23 times, and the TSX which is 18.5 times. We're already starting to see a lot of our institutional investors overweight Japan in some of their international holdings as well.”
From a sector perspective, Lee is constructive on Japan’s consumer discretionary and consumer staples sectors, which Japanese equity indexes have a healthy exposure to. While they’re largely domiciled in Japan, those companies – which include the likes of Sony, Nintendo, Honda and Toyota – tend to have global sources of revenue. At the same time, the wages they pay haven’t really grown, which means their costs are relatively static.
“Because their revenues come from around the world, those revenues may increase with inflation, especially if they’re able to hedge out their currency exposure,” he says. “And even though Japanese companies don’t market their products as high-quality to the extent American companies do, Japanese goods have a reputation for high quality.”
While it’s very difficult to come up with a blanket recommendation for all investors, Lee estimates that a 5% to 10% weighting to Japan would be a healthy amount to consider in a portfolio. On the institutional side, he says more large investors that have international exposure are overweighting to Japan as they retreat from European assets that have exposure to Russia and Ukraine.
“It might have been difficult for investors 20 or even 10 years ago to get exposure to Japan,” he says. “But because of the innovations that have taken place in mutual funds and ETFs, it’s gotten a lot easier for ordinary Canadians to get that access.”