April 2018

INSIDE VIEW: Japan defeats its sceptics

Kiyomizu-dera TempleProfit margins in Japan have surged even though GDP has been subdued. John Vail of Nikko Asset Management explains why.

There always have been some legitimate questions about the growth outlook of Japan. In the past few years, however, the sceptics have been pleasantly surprised, not only regarding economic growth but even more so the growth of corporate earnings.

Looking ahead, while Japan’s GDP for the first quarter may stagnate on a quarter-on-quarter basis, it will still likely register 1.7% year-on-year growth and remain around that level for the rest of 2018. While seemingly small, this is actually strong growth for Japan and compares very favourably on a per capita basis with US GDP growth.

Also, important for investors to know is that declining demographics, while normally causing somewhat slow GDP growth, has not correlated with poor corporate profits in the case of Japan. Its technological improvement has defeated this headwind, as has its strong structural improvement in corporate governance.

Indeed, despite quite modest GDP growth in Japan for the past two decades, improving corporate governance has led to a strong increase in corporate pre-tax profit margins. Both manufacturing and non-manufacturing companies have experienced similar margin expansions, and while this profit margin has plateaued recently, it is unlikely that this is the beginning of a downturn unless the global economy unexpectedly sours. It is noteworthy that 2016 experienced a similar plateauing pattern only to move sharply higher later.

Surging margins
The long-term prioritisation of corporate profitability is shown by the divergence in profit margins from the GDP growth trend (see chart opposite), showing that even though the former has remained subdued, profit margins have surged. Since the early 2000s, Japan has embarked on major rationalisations in most major industries, with the number of players usually reduced from seven down to three or four.

Indeed, several enterprise conglomerates have merged a large number of their competing corporations, like the Mitsui and Sumitomo groups, while in the banking industry, major banks once numbered nearly a dozen, but have since been reduced to four. The chemical, steel, insurance, consumer electronics and semiconductor industries experienced the greatest consolidations.

As for autos, while it may seem that there are many players, several are now highly aligned with the Toyota group in a somewhat similar way to foreign makers with several brands.

The fruits of this restructuring were slower to ripen than in Western-world examples, often due to the slow elimination of excess workforce, and they were hidden by a series of crises (the global financial crisis of 2008-09, the strong yen period of 2009-12, the severe Thai floods in 2011 that halted a large amount of auto and electronics production, several periods of political turbulence with China that included boycotting many Japanese goods and, of course, the tsunami/nuclear crisis of 2011). But since prime minister Shinzo Abe introduced his ‘Abenomics’ policies, the global backdrop for Japan has been stable and there have been no domestic crises, thus allowing these fruits to ripen in a way that shocked many observers.

The fruits have not just been lush corporate profits, but the ability to compete in global markets and provide efficient services in the domestic industry as well. The resulting social stability, long cherished in Japan, and environmental cleanliness have also led to surging tourism. Tokyo looked like a ghost town in the year after the 2011 earthquake, but today it is almost overrun with tourists.

Many Asian tourists appreciate the regions outside of Tokyo as well, for skiing in the winter or fresh mountain air and mineral baths that are rare in many parts of Asia. Many regions were hollowed out by the restructurings mentioned above and many smaller cities now are fractions of their former selves, with rusted and shuttered storefronts, factories and empty homes, but quite a few of them are now on the upswing due to tourism.

This diversity of economic growth away from the cities is an important trend, both politically and economically, for Japan. It reduces the kind of social instability and fracturing currently seen in the US and many other countries. Tourism also tends to be quite profitable and labour-intensive, while in Japan’s case, it is also environmentally friendly.

As for the other key factor for a demographically challenged country, technological improvements have clearly been Japan’s bright spot. Although they might have Korean or Japanese names, smartphones usually rely on Japan for many of the most advanced miniaturised parts.

Japan leads the world in advanced robots and other machines for factory automation. Hybrid and electric cars, electronics for commercial video and audio production, and industrial pollution-control equipment are all fields dominated by Japan, along with many others.

Japan does not possess many world-famous universities, but they are major innovators and their graduates are working effectively in corporate research and development centres.

Corporate leaders in Japan, meanwhile, are rarely lawyers or short term-oriented managers, but engineers, PhDs or long-time staff who can work closely with their engineering teams.

Decades ago this led to rigid corporate governance in many cases, which lowered profitability and returns to shareholders, but as mentioned earlier, this lesson was learned long ago and good governance has now become de rigeur. The new corporate codes of conduct issued during the Abe administration have reinforced this trend.

In sum, Japan has faced many challenges and yet economic growth, corporate profitability, national competitiveness and social harmony are solid.

John Vail is chief global strategist at Nikko Asset Management

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