National Conference on Public Employee Retirement Systems

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Clouds Clearing in the Land of the Rising Sun

By: Kyle Concannon, William Blair Investment Management

On the back of five recent trips to Japan, the William Blair global equity team has been increasing Japanese equity exposure across international strategies over the past few quarters, narrowing the underweights that had been held for some time.

This is an excerpt from NCPERS Spring 2024 issue of PERSist, originally published April 25, 2024.

From the 1970s through the 1990s, Japan was a world leader. Its economy was growing, and it was a dominant player in a few different industries. Then its nominal gross domestic product (GDP) growth began to stagnate. Then its nominal gross domestic product (GDP) growth began to stagnate due to a complex interplay of factors. But we're now more bullish on Japan. In this article, I highlight three specific reasons.

An Improving Macro Environment—for the First Time in Decades
If we look at the decomposition of Japan's real GDP growth year over year, we can see that it's starting to come from consumption.

That means people are actually spending money. And after decades of zero inflation or deflation, Japan is finally experiencing inflation.

Now the question is whether this growth in gross domestic product (GDP) and the uptick in inflation are sustainable? We believe it is because Japan's labor market has changed.

One of Abenomics' three arrows, which sought to revive the stagnant Japanese economy, involved structural reforms to increase labor force participation—in particular, to get more women into the workforce. This push was successful, but even with labor force participation increasing over the past decade, there are now roughly two job openings for every job seeker in Japan. The unemployment rate is 2.4%, down from 5% 15 years ago, and a tight labor market typically leads to wage growth.

This is similar to what we saw in the United States and Europe a couple of years ago. Real wage changes were initially negative as inflation increases outpaced wages. But then, as broader inflation normalized, those economies experienced positive real wage growth.

Structural Tailwinds Developing
A second reason we're increasing exposure to Japan is that we've seen several reforms that could act as structural tailwinds.

Corporate Governance Reforms
In terms of board independence, separation of CEO and chair, and female directors, Japanese companies rank well behind its developed market peers and even behind most emerging markets. Japanese companies also have the highest number of directors over age 70. But recent revisions to Japan's corporate governance code, effective April 2022, seek to tackle all of this. For example, they seek to have a minimum of one-third of board directors be independent and more women on boards (setting a target of one female director by 2025 and 30% female directors by 2030). This should create better alignment between decision-makers and investors, which we believe will lead to enhanced risk management, better decision-making that focuses on value creation, and ultimately, better shareholder return.

Stock Exchange Reforms
Many Japanese companies desperately need to improve returns and capital efficiency. For example, 43% of Japanese stocks listed on the TOPIX 500 have a price-to-book (P/B) ratio of less than one, meaning you can buy the company for less than its book value. In the United States (S&P 500 Index), that number is just 5%, and in Europe (STOXX 600 Index) it is 24%.
Similarly, 40% of Japanese stocks listed on the TOPIX 500 have a return on equity of less than 8%. In the United States, that number is just 14%, and in Europe it is 19%. The Tokyo Stock Exchange is leading reforms by urging all companies with a P/B ratio of less than one or return on equity of less than 8% to devise a plan to improve capital efficiency and promote investment. Companies that do not develop such a plan will be named and could be delisted. We believe this “name-and-shame” campaign should lead to good outcomes for the companies and its investors.

Tax Incentive Reforms
A third structural tailwind is a change to Nippon Investment Savings Accounts (NISAs), which are tax-exempt investment accounts designed to encourage personal investment in stocks and mutual funds by offering tax exemptions on capital gains and dividends from investments held within these accounts. New NISA rules that took effect in January 2024, when combined with an uptick in inflation, create a significant incentive to put cash into financial instruments rather than a savings account—which we believe will drive flows into domestic equities. This could be a multiyear liquidity event for Japanese financial instruments.

A Compelling Bottom-up Story
Lastly, groups of global equity team members have traveled to Japan five times since the fall of 2022, and all returned with a positive outlook—not just because of the macro-outlook, but because of the potential for multiples to expand. The companies we spoke to believe disinflation is dead, inflation is real, and they can finally pass on price increases to the consumer. They also plan to increase wages as prices are passed through. So, what we are seeing is bottom-up confirmation of a compelling top-down story.

This article is excerpted from our blog, which you can read in full here.

About the Author
Kyle Concannon, CFA, CAIA, is a portfolio specialist for William Blair's global equity strategies. In this role, he participates in the team's decision-making meetings, conducts portfolio analysis, and is responsible for communicating portfolio information to clients, consultants, and prospects. Previously, Kyle was an investment strategist on William Blair's Dynamic Allocation Strategies team where he contributed to portfolio management and was responsible for communicating the team's philosophy and process, portfolio positioning, and performance drivers to internal and external stakeholders. Before joining William Blair in 2015, Kyle spent eight years at UBS Global Asset Management, most recently as part of its global investment solutions team, where he was responsible for interacting with clients and prospects regarding the firm's multi-asset capabilities. Kyle is a member of the CFA Institute, the CFA Society Chicago, and the CAIA Association. He received a B.S. in finance from Boston College.


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