By Bill Witherell, Ph.D.
The Japanese economy, the globe's third largest (following those of the US and China), shrank by a record 7.8% in the second quarter. This decline was less than the 9.5% fall in the US economy and the 10.1% drop in the German economy. However, it was more than double neighboring South Korea's 3.3% drop. Taiwan's GDP eased only 0.7%. Japan, like South Korea and Taiwan, was able to avoid strict pandemic lockdowns, but its economy was already in decline the previous two quarters, hit by the US-China trade war and a sales tax increase before COVID-19. In the second quarter, private consumption suffered during a five-week national state of emergency, and at the same time exports dropped sharply due to the decline in the global economy.
July data indicate the third quarter is also off to a difficult start in Japan. Markit Economics reported that the au Jibun Bank Composite Output Index (manufacturing plus services) for July was 44.9. This is up from June's 40.8 reading and is the highest since February. Nevertheless, the index remaining below the 50.0 no-change mark, as it has for six consecutive months, indicates that the private sector was still declining at the start of the third quarter. Companies reported that weak demand reflected subdued global trade, continued social distancing, and border restrictions. The value of exports in July was down 19.2% compared with the July 2019 figure, which is an improvement over June's 26.2% YoY decline. Business expectations are for improving activity in the next 12 months.
It now looks like Japanese GDP will contract by 6% in 2020, while the OECD is projecting growth of 2.1% in 2021. The government has implemented measures equal to some 40% of GDP to aid the economy, including job-retention subsidies, loan guarantees, and cash handouts, while the Bank of Japan has been extending cheap loans and purchasing ETFs, commercial paper, and corporate bonds. Further stimulus actions are looking increasingly likely in view of the weakness in the recovery thus far and recent increases in COVID infections.
Uncertainty is great concerning future developments in the pandemic and its effects on Japan's and the global economy. In Japan confirmed cases started to rise significantly in March, accelerated in April, and then appeared to peak. Confinement measures were largely voluntary, including stay-at-home requests. Public schools were closed from mid-March and just reopened August 17. Under a state of emergency, nonessential businesses were closed between mid-April and mid-June.
The rate of infections has again been rising in recent weeks, with Tokyo raising its alert to the highest level. Bars must close by 10 PM. Yet these developments in Japan need to be kept in perspective. The nation's total death toll at the time of writing was just 1,132, despite the very high share of elderly in the population. Japan's rate of coronavirus deaths per million people is 8.8, compared with 514.9 deaths/million in the US. Also, Japan's cases/million is 446.8, compared with 16,362/million in the US.
Japanese stocks tumbled earlier in the year along with most stock markets as a result of the global pandemic and its effect on economies. Stocks have been recovering since early April. Year-to-date August 18, the iShares MSCI Japan ETF (EWJ), is down 0.8% on a total-return basis. Over the past 12 months, its total return is 11.3%. Over this period, EWJ outperformed the broad iShares MSCI All Countries except the US ETF ACWX, which had corresponding total returns of -3.1% and 9.5%.
While economic growth in Japan is likely to remain modest, Japanese business earnings appear to be improving, with positive surprises predominating. One encouraging factor is the improvement being registered in corporate governance standards, including a rise in the appointment of external directors, a drop in anti-takeover measures, and progress in dismantling the webs of cross-held shares. Japan's prime minister, Shinzo Abe, included corporate governance reform as one of the most important challenges in his Abenomics growth strategy. A stewardship code was enacted in 2014, followed by Japan's corporate governance code in 2015. Both were updated three years after enactment.
Their objective is to achieve high-quality governance that will yield increasing corporate value and sustainable economic growth. One sign of progress is that the percentage of listed companies that have appointed more than one independent director increased from 21.5% in 2014 to 93.4% in 2019. Cross-shareholdings as a percentage of total market capitalization were well above 30% in the 1990s but now have declined to under 10%. This development should reduce the protection of underperforming management and free locked-up capital that could be more efficiently deployed elsewhere.
The Asian Corporate Governance Association has noted that Japan still has a ways to go. Improvements are needed in the process of nomination of directors and in chief executive officer succession. Beneficial shareholder identification is another area needing attention. We believe that strengthening corporate governance over time improves the attractiveness of a company to investors. Cumberland Advisors continues to include Japan in our International and Global portfolios.
Cumberland Advisors holds EWJ and ACWX in its investment portfolios. The author does not hold either of these ETFs in his personal investments.
Sources: Financial Times, etf.com, acga-asia.org, kyodonews.net, strategy-business.com, oecd.org, responsible-investor.com, ihsmarkit.com, GS Macro Economics Research.
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