Are Japanese Equities Cheap?

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, GSJY, HEWJ, HFXJ, HJPX, JEQ, JPN, JPNH, JPNL, JPXN
by: Long/Short Investments

Summary

Japan is a low-growth and low-inflation economy; neither condition on its own is conducive to strong appreciation in equities.

However, the BOJ’s quantitative easing program is unprecedented in scope relative to the size of Japan’s economy, directly incentivizing financial investment.

I value the Japanese equities market using a discounted cash flow model, providing a valuation range based on growth and risk premium adjustments.

Japanese stocks may provide better inflation-adjusted returns relative to US stocks, but associated risk/volatility is higher.

Japan has several structural economic issues, most notably with respect to aging demographics and the highest debt load as a percentage of economic output of any society, past or present.

There is no easy solution to Japan’s economic problems. When considering the two fundamental components of GDP growth – increases in productivity and increases in the number of hours worked (i.e., population growth) – the country struggles with both.

The average age in Japan is approximately 47 and in the latter half of the century, the country will have one individual aged 65+ for every working-age individual between 20-64. This places an enormous burden on entitlement programs. Without some combination of increased birth rates, immigration, spending cuts, and/or a productivity boom, the debt situation and economic squeeze will grow progressively worse.

Non-seasonally adjusted productivity has flat-lined since the financial crisis:

On the matter of population growth, high life expectancy and sub-replacement fertility rates (1.4 births per woman in 2016) are likely to see Japan’s population reduce from 128 million in 2011 (its peak) to 88 million by 2060.

(Source: Japanese government projections)

Given individual workers – both the collective sum of their productivities and the growth in their number – work to determine how fast an economy grows, this has big implications for Japan moving forward.

The BOJ in a sense is considered a leading experimental ground for other central banks. Namely, this includes the EU and US Federal Reserve – who collectively preside over roughly 45% of global economic activity – given secular stagnation is so fiercely ensconced in the country’s long-term economic picture.

Overnight rates are pressed down against zero (actually slightly negative), and this is considered almost a permanent policy at this point. The BOJ’s balance sheet stood at ¥511.6 trillion in August (approx. USD$4.6 trillion or about 92% of GDP). By comparison, the Fed’s $4.5 trillion balance sheet stood at approximately 24% of US GDP and is slowly being unwound from this figure.

At the same time, the BOJ has been slowly paring back its asset purchases from its ¥80 trillion per year guideline (image below), though the concept of a “BOJ put” (i.e., expectation that the BOJ will effectively bail out markets if they drop too significantly) is still a widely held belief. Given quantitative easing programs operate through the conduit of the financial markets – i.e., to lift asset prices and create a “wealth effect” – central banks remain highly sensitive to financial asset valuations.

Therefore, such programs incentivize financial investment (particularly in higher-yielding risk assets). This has created the perception of a market that has limited downside given the power central banks have at their disposal to inject liquidity into the financial system.

Valuation of Japanese Equities

To value Japanese equities (EWJ), using the Nikkei 225 index as a proxy, I look at its earnings yield, short- and long-term growth rates, the country’s return on cash holdings, and use a risk premium (i.e., expected return over cash) to project a valuation range for this asset class.

As of October 12, Japanese equities had an earnings yield of 5.33%. On average, we might expect 80% of those earnings to go back to shareholders, with the other 20% reinvested back into the business, though this number varies based on the economy and assorted incentives.

Real growth in the economy currently stands at a 1.4% year-over-year rate, with CPI inflation at 0.7% annual clip. The country’s cash rate, taken as its 3-month government bond, stands at -0.133% as of the time of writing.

Short-term growth is set equal to the long-run growth (2.1%, or 1.4% real growth plus 0.7% inflation). The pairing follows the premise that stocks can’t out-earn the growth rate of the broader economy indefinitely.

In terms of a risk premium – namely, the return investors expect over cash – 6% is a pretty standard annual return expectation in current equity markets. It’s no longer realistic, in my view, for investors to expect 7.0%-7.5% inflation-adjusted returns going forward unless we get some massive growth boom.

A 6% premium isn’t much for an asset class that historically generates 18%-19% annualized volatility – approximately 26% higher than US equities – but returns are unattractive in all broad asset class categories at this stage of the cycle.

Nonetheless, we can use both growth rates and risk premiums as inputs that can be adjusted over a reasonable scale, such that a representative valuation range can be determined.

Inputting all of the above base assumptions would place the fair value of the Nikkei 225 index at 23,780, or 13%-14% higher than its 20,955 reading. However, given the cash rate in the Japanese economy is slightly negative, this would project forward annualized nominal returns of 5.9% (6% risk premium plus a (negative)-0.1% return on cash).

If we want to back out the risk premium associated with the current value of the index, we get 6.50%, or about 6.4% forward nominal annual returns.

This is attractive relative to other Japanese assets when the entirety of the Japanese yield curve is under 1%.

(Source: Bloomberg)

US stocks, by my own projections, offer about 6.8%-6.9% forward nominal returns assuming interest rates stay around where they are. If we factor in inflation, this would provide around 5% in real returns. Similar to the Fed, the BOJ targets a 2% inflation figure and the timeline for reaching this level is consistently pushed back. With Japan’s deeply embedded economic headwinds, this will be difficult to achieve and the market is right to expect it to consistently underachieve this mark.

Though unemployment is ostensibly low with a 2.8% jobless rate, this is a contrived figure that ignores the massive degree of underemployment and discouraged workers in the Japanese economy that creates a large degree of shadow slack in the labor market.

Therefore, if we assume 1% inflation is a more typical long-run expectation – again, given the entire yield curve is under this figure, even 1% could be optimistic without substantive policy alterations – this would estimate Japanese equities at about 5.4% in long-run real returns, slightly higher than that expected of US equities.

If we assume short- and long-run nominal growth of 2.1% for the Japanese economy, a 6%-7% required return over cash would place the index at 18,800-23,780. Graphically the full-range of outcomes is shown below.

(Source: author)

If the risk premium is assumed to be at 6%, and short-term and long-term nominal growth runs from 0%-3%, the downside from current valuations looks to be around 30%, with around 45%-50% upside. At this level, the market currently implies around 1.6% nominal growth. This is lower than the BOJ’s inflation target itself and 50 basis points below where nominal growth is currently estimated.

(Source: author)

Accordingly, it’s fair to say that Japanese equities already price in a fair amount of bearishness with respect to the country’s future growth trajectory.

Conclusion

Japan’s economy is mired in a woeful state due to secular forces that are beyond its immediate control – namely, extremely high public debt load, aging population burdening entitlement programs, and low birthrates that will squeeze economic growth over the course of several decades.

This means interest rates will be reduced down to nothing for the foreseeable future. And while quantitative easing may have a questionable impact on the real economy in terms of stimulating consumption and capital investment, it does directly incentivize financial investment and those who benefit from “riding the tide.”

Japanese equities look cheaper than US equities when looking at forward inflation-adjusted terms. But they are also riskier, with the factors of higher historical volatility and long-run growth headwinds more severe than in any other developed market.

Combined with the massive leveraging of its economy, any mild increase in rates can pressure the government’s ability to service its debt and lead to increasingly unsustainable deficits. The government can always pay its debt in nominal terms under a fiat monetary system but at the expense of a (perhaps severe) devaluation. Therefore any Japanese investment only makes sense in the context of interest rates remaining low indefinitely.

So while in inflation-adjusted terms, forward returns of Japanese stocks may look better relative to US stocks (though is dependent on one’s beliefs about each economy), this comes at the expense of higher risk and higher expected volatility as policymakers deal with a very thorny situation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long various Japanese equities