From our offices in Tokyo, portfolio manager Dan Maguire joins host Thomas Mucha to discuss the massive economic and market implications of Japan's efforts to end deflation.
From our offices in Tokyo, portfolio manager Dan Maguire joins host Thomas Mucha to discuss the massive economic and market implications of Japan's efforts to end deflation.
1:45 Japan's economic recovery: Exiting deflation
4:35 Structural shifts in Japan’s labor market
6:35 Japanese zombie companies and the drive for efficiency
8:25 Outlook for Japanese small caps
11:05 Geopolitical impacts on Japan’s financial market
14:40 Assessing Japan’s attractiveness versus other markets
18:10 Personal observations on investing in Japan
MAGUIRE: One of the typical descriptions of Japan is it’s a place where change happens very slowly, but I’ve always had a bit of an issue with that. I don’t think that’s accurate in the sense that… Japan’s a place where it takes time for change to occur, but when change occurs, it’s fast. And I think that’s where we are.
MUCHA: Today’s topic is Japan. In December, the Bank of Japan took an unexpected step, lifting its longstanding yield-curve control to allow 10-year government bond yields to rise to 50 basis points. That was from a target of 25. Then, at its January meeting, the BOJ maintained that stance. Now, the official line is that this is designed to restore bond market functioning, but our experts on Japan believe the reasons are more politically nuanced and may signal structural shifts for Japan, and potentially for the global economy. And that’s before considering all the key geopolitical developments that are ongoing in the region. Here to talk about the near- and longer-term market implications is Dan Maguire, a Japan specialist and equity portfolio manager who specializes in Japanese and international small caps. Dan joins us today from Tokyo. Dan, welcome to WellSaid.
MAGUIRE: Thanks, Thomas. Thanks for having me today.
MUCHA: Now Dan, given the BOJ’s recent move, let’s start with Japan’s macro picture, and specifically, I want to get into Japanese consumption. So how might this shift by the BOJ impact domestic households and business spending and investment across the Japanese economy?
MAGUIRE: So, this is an extremely broad and wide-ranging question that has an extremely wide range of outcomes. When you look at, really, the most critical component of the Japan story, it’s really the exiting of deflation. And that deflation has been in place for the past 25 years, or thereabout. And it really come about as a function of Japan’s insistence to drag out a cathartic process of sorting out a lot of the issues that were created by the bubble in the late ’80s. It really set into place a function of inflation expectations really anchoring to the downside. That’s had knock-on implications in Japan for, I’d say for the past 20, 25 years or so. There’s been no real wage growth in Japan for the past 25 years. There’s been no net investment growth in Japan for the past 15 years. And it just meant that the accumulation of capital just ground to a halt in Japan, really. That’s the most primary force in modern capitalism. You’ve really got to take it from the perspective of are we exiting deflation, do we start to see real wages start to grow in real terms? And do we start to see a true sustained investment cycle? Well, the indications we have right now, working closely with our macro teams and also what we see from talking to corporates and management teams on the ground, is that we’re starting to see the initial stages of all three of those different components coming together. This BOJ focus right now, particularly around inflation and their response to it; the exiting of the zero interest-rate program, it’s all linked. It’s all connected. But the real key to everything is exiting deflation. So, I sat in a presentation listening to Kuroda-san, the head of the BOJ, and the way he described it was an economy in deflation is like putting an economy into deep freeze. By exiting deflation, we’re in the initial stages of bringing the Japanese economy out of that deep freeze that it’s been stuck in for the past 25 years or so. And the implications are obviously substantial. From a consumption perspective, getting that consumption moving again. Breaking down that mindset that everything gets cheaper every single year: Why invest now when everything becomes cheaper next year? It really becomes a really negative spiral, that if we can break out of that, that has really, really big implications. And just as a side issue, as I’m sure you know, Japan has 2,000 trillion yen of household savings sitting idle.
MUCHA: So, on this core point about deflation, what’s your gut tell you? Is this going to work? Is this the end of deflation in Japan? Is this the end of stagnant wages for Japan?
MAGUIRE: In a word, yes. There are multiple different ways you can view this, but one of the really interesting pieces of this real wage-growth story is the generational shift. The steady breakdown in the lifetime employment system in Japan, it’s real and it’s tangible. And that’s creating the need for labor mobility. So, people are starting to change jobs more frequently, more actively. People are searching out jobs with higher compensation associated with them. And I think many of these different pieces have been catalyzed by COVID. In terms of people prioritizing what they really want to do with their work time. But then on top, some of the external pressures that are manifesting themselves in Japan, it’s creating a series of factors that are all driving more competition for labor. The better-quality companies are having better success in attracting better quality people because they can pay out more. They can offer more flexible working environments, etc., etc. That’s creating a crack in the way in which the labor market is structured here. So, when you take those pieces together, and you start to see instances of really big blue-chip companies in Japan raising wages by anything between 6 to 7 percent, to up to 40 percent in some cases. And when you speak to the managements of these companies, they’re very open and active in terms of, they want to attract the best people. We’re hearing it from staffing companies, from recruiting companies. And it’s interesting, because obviously we meet a lot of these management teams, we’ve been meeting them for many, many years, and it’s something that we always address in terms of sourced labor right now, can you source it, how much does it cost? And because those expectations were so anchored to the downside for so long, it was always discounted. There would be no need to raise wages anymore than inflation, which is, it’s obviously negative. It’s been a complete about turn over the past 18 months or so.
MUCHA: That’s fascinating, Dan. So, more on this, the corporate impacts here. On the other end of the spectrum, we have these so-called zombie companies, those that have been propped up by lenders over the years. I understand that many of these zombie companies are coming back, most recently thanks to pandemic loans that they’ve gotten. Does the BOJ have these unproductive, highly inefficient operations in its sight?
MAGUIRE: Yeah. The really big story, I would say, was really all about efficiency in Japan. It’s driving efficiency and pushing out these zombie companies. So, the situation we have forming right now, yes, the government has supported a lot of these companies through COVID, a lot of forced lending programs, as in many other parts of the world. What’s changing now though is that a lot of these companies cannot, will not be able to survive in an environment where you have rising labor inputs and rising raw material prices. So, what we’re likely to see right now is a consolidation of the stronger getting stronger. Demographics gets held up often as a negative component, this is actually driving some of this consolidation now, in terms of a number of these smaller-sized companies having no natural succession plans. And when you put all of this together as well, one of the big changes that’s happened over the past, since the onset of Abenomics actually, is really this shift in corporate governance. The drive now to allocate capital in a more efficient way. Private equity has finally made its way to Japan, and is now making big inroads, primarily into larger-sized companies, but this is going to be the next step, the natural evolution will be into the smaller-sized companies. And deals are being done now. There’s a plethora of M&A brokerage companies that have appeared over the past few years, particularly to take advantage of this consolidation that’s occurring in this smaller, SME segment of the economy.
MUCHA: So, Dan, how does this impact your area of expertise? Of course, I’m talking about small caps here. What kind of opportunities are you seeing as a result of these big changes?
MAGUIRE: The small- and mid-cap sector in Japan is really where the most exciting stories lie. There’s more companies in Japan than there are in the entirety of Europe combined. And there are a huge amount of really, really good focused, world-leading companies that operate in that SME space. The coverage in this area, on the sell side, is extremely thin. It's actually the thinnest of all developed markets. It’s woeful, actually. The mispricings in the small- and mid-cap space are dramatic. But as I said, there are some really, really well-managed companies there that will come out of this that generally tend to respond the best when you have tougher environments. So, they will have the best responses to whatever kind of situation that had been thrown at them, whether it be higher input costs, higher labor costs. They innovate more effectively. They can hire the best people. And that all manifests itself in corporate earnings over time. And that is what I would likely expect to see going forward, is some of these high-quality, small- and mid-cap sized companies growing into becoming much stronger, bigger companies over time, driving efficiencies. There’s a variety of different areas where Japan is still lagging notably versus other parts of the world. And it all comes back to the point that we mentioned right at the beginning, in terms of Japan has had very, very limited net investment over the past 15 years. There needs to be an investment cycle in order to drive this efficiency push. And the current situation that we have right now in terms of inputs going up, labor cost going up, difficulties with sourced labor, is exactly the stimulus we’re looking for in order to drive that, and kickstart that process.
MUCHA: Sounds like a bit of a stock picker’s paradise across the SME sector.
MAGUIRE: It is. It’s full of so many different exciting stories. But to put actually one caveat around this, is that the small- and mid-cap space, after decades of outperformance, has actually struggled over the past four or five years or so. One of the primary reasons for that was the Bank of Japan’s buying program. So, up until now, all the focus I guess has been around the Bank of Japan’s bond-buying program, and the YCC program, but back in 2015, the Bank of Japan started buying equities. They were the only central bank across the world to actually be buying equities. And that created a lot of distortion with regards to the price discovery process. That program has all but wound down now, and what we’re starting to see now is that price-discovery process coming back into focus, which should be good, all else equal, should be good for these small- and mid-cap companies.
MUCHA: Now Dan, you’ve been very eloquent in describing the seismic changes in the monetary environment in Japan. That’s also happening in the geopolitical front, given Japan’s key national security role in the region, the shifting domestic political concerns we’ve seen in Tokyo. So, I’m wondering as a portfolio manager, how are you thinking about the broader changes in Japan’s geopolitical backdrop, the region’s geopolitical backdrop? And what does this mean to the attractiveness of the Japanese market? We’re clearly seeing a bigger shift towards defense, a larger Japanese role in these great-power competition stresses, a closer military alliance with the US, Australia, India, and others. So how does this more acute national security direction impact your views?
MAGUIRE: There was a period during, while Abe was leading the government, where Japan was trying to tread this very fine line in being kind of in between. So, China is Japan’s largest trading partner. It obviously plays a critical role in Japan’s economic development, how it fits within that Asian context. Obviously over time, as relations between China and the US have deteriorated, that’s forced Japan’s hand to a far greater degree. And now the balance is definitely and quite clearly, shifting to the US side of things. That has a lot of implications from a societal perspective… been a pacifist society for the, for the past 70 years or so. Opinion is definitely changing, though, domestically. And particularly the war in the Ukraine, it's actually driven this realization that Japan needs to rearm. An often forgotten point, but Japan is one of the biggest military spenders in the world. The opportunities from an investment perspective, however, are obviously pretty limited in Japan, their reliance on the US is extreme. But Japan does play a very interesting role, in that Japan controls a lot of the key critical materials that are used in a lot of the high-tech industries. So, the development of the semiconductor industry across the world is highly dependent upon a lot of Japanese companies that will supply the materials that go into the production of these electronics and semiconductors and in multiple different stages of the manufacturing process.
But it's something that we spend a lot of time with you and a lot of our colleagues internally trying to get a better handle on where Japan will sit coming out of this current really quite difficult situation from a geopolitical standpoint.
MUCHA: Yeah, I think you’ve identified the key issues here. And I do think we’re at the beginning stages of a long-running trend here that’s going to put more focus on national security. In my conversations with policymakers here and Brussels and London and elsewhere, Japan is central to these discussions. And so, I think you and I are going to have more conversations in the future, Dan, about this stuff.
MAGUIRE: It’s such a difficult topic to try and address. But interestingly, Japan’s recently announced a huge increase in its defense spending. Public awareness of the need to rearm is rising. And this was really started from Abe, back in 2013 to ’14, when all of his efforts to try and change the Constitution got pushed back, and I think a lot of what’s going on right now in the Ukraine has strengthened the case. As you’d expect, in a country that has very high taxes, there’s huge pushback in terms of how they’re going to fund this, because the consumer really doesn’t want to pay for it. So, that’s a topic that we’re focused on, in terms of how Japan is going to try and pay for all this defense spending.
MUCHA: Japan is not alone in that question, of course. Now, we’ve been talking about big structural changes across Japanese society, and the geopolitical environment, the macro environment. How do you think all of this stacks up from the investment perspective? And what I mean here is, how does Japan look compared to other developed markets today?
MAGUIRE: It’s a great question. And I work on a team that specializes in international stocks. So, valuations are now at decade lows, relative to other developed markets. Secondly, you have a currency tailwind that is helping to support a lot of the export sector right now, which is also acting as a definitive tailwind in this environment. Thirdly, you have a process that’s been in place over the past decade or so where margins and returns, nonfinancial sector margins have just been gradually increasing, over the past decade. The reasons for Japan to be cheap 15 years ago were often centered in the arguments that profitability was low, capital returns were low. Both of those components have now started to change, So, profitability levels have now risen to similar levels that Europe and the US, maybe a little bit behind the US, but they’re trending in the same direction. At the same time, the capital-return component, which is the really big bugbear of why it was pointless investing in Japan — as many of the bears used to raise — was that even if companies generated a lot of free cash, you would never get your hands on it. The changes in the corporate governance landscape are huge. So, all of the sudden corporates are now paying out more of the cash that’s been generated, either in the form of paying out dividends, or in the form of buying back stock. And that’s taking hold as well. And at the same time, Japan’s on a different economic cycle than other parts of the world. As Japan is just reopening now, and has only recently reopened its borders, we are starting to see economic activity pick up again. The F&B sector is recovering, tourism is starting to recover again, it’s linked into China reopening, obviously very closely. So, you’re having this cyclical rebound as well, at the same time that you’ve got decade low valuations, improving capital dividends or buybacks. Now you have this extra component that’s added on with regards to the BOJ actions and what potential implications that could have. There’s far more positives that are occurring and unfolding right now than there are negatives. And relative to other parts of the world, that looks really quite attractive right now if you’ve got the mix of all those different pieces together, all coalescing at the same point in time.
MUCHA: You make a strong argument there.
MAGUIRE: I think it’s an exciting time for Japan. But, after many years of watching Japan, one of the typical descriptions of Japan is it’s a place where change happens very slowly, but I’ve always had a bit of an issue with that. I don’t think that’s accurate in the sense that… Japan’s a place where it takes time for change to occur, but when change occurs, it’s fast. And I think that’s where we are. That’s the position we’re in right now. And the fact that Japan has been off the radar for so long, sell-side coverage is very, very thin. The specialists that are out there now, they’re actually have been tracking and have the time series, can actually see the change, and can put that into context. So we try and look at Japan in a way that… It’s, like it’s an oil tanker. It’s a huge, massive economy. It takes time for it to change. As that tanker starts to turn, then you do start to see change, particularly if it’s coincident with external pressure, which is exactly the situation you have now with this broad inflationary dynamic that’s unfolding. So, yeah, it’s definitely an area that we’re putting a lot of time and effort into now to really try and identify where we see the most potentially attractive opportunities going forward.
MUCHA: Now Dan, as we wrap up this conversation, I want to move from sort of the 30,000-foot view where we’ve been hanging out here more to your personal views or personal observations. You’ve been in Japan for a long time now. What advice do you have for investors who may be unfamiliar with Japan? What do they need to know about the country and how to invest in it?
MAGUIRE: Yeah, it’s a great question, because we get that a lot on our team. Internally, we have many people asking us exactly the same question. And there’s been a narrative that’s developed over time in that in order to be successful in Japan, you have to invest in a different way. It’s a different place, therefore different rules apply. And our response has always been the same, is that the rules are exactly the same. The core underpinning component of corporate value expansion is free cash-flow expansion. You focus on companies that know how to do that, know how to drive it, you’re going to be right more often than not. There’s cultural differences, clearly. So, appreciating the cultural differences. But the big thing that we try and push to our colleagues is that there are far more similarities than there are differences. So, rather than solely focusing on the differences, try and identify where the similarities are. And when you look at it through that lens, you start to see the commonalities in the similarity of business models, successful business models, unsuccessful business models. And that just builds over time. But there’s no better way to experience Japan than jumping on a plane and getting over here and actually experiencing it for yourself.
MUCHA: So, for those people who are hopping on a plane, flying to Japan, it’s a long flight, particularly from the US. Are there any good books that you could recommend that would help these travelers better understand the country, the culture, the markets?
MAGUIRE: There are so many books that are out there. One of my favorite books is The Yamato Dynasty by Sterling Seagrave. That’s a really fun book that just explains a lot of the history leading up to the First World War to modern-day times. It’s a really fun book. From an economic perspective, Japan Rising, is a really good book by Kenneth Pyle. That’s a really good read and one that I go back to every now and again. Once you go down that rabbit hole of books on Japan and the Japanese economy and the bubble economy, you start to unearth a whole subculture of literature on these topics.
MUCHA: All right Dan, last question. And we like to end these conversations with our usual what-if question for investors around the firm. So, if you weren’t a successful portfolio manager here at Wellington, based in Tokyo, what other career would you like to have?
MAGUIRE: I would like to be… I would like to be teaching skiing in Japan. I’d like to be, yeah, I’d like to be generally just skiing every day, I think.
MUCHA: So, a ski bum in Hokkaido, is that the dream?
MAGUIRE: I think that would be the dream, yeah.
MUCHA: Can I come?
MAGUIRE: More than welcome. There’s a growing selection of ski bums that I’ve worked with in different guises over the past few decades, that are now all in Hokkaido, doing exactly that. I’ve skied in many places over the world but there is nothing like skiing in Hokkaido. It’s like skiing in sugar.
MUCHA: All right, well you don’t have to ask me twice to come join you to do that, Dan, it’s also on my bucket list. So, let me thank you again for your time today. Once again, we’ve had Dan Maguire, Japan specialist, equity portfolio manager, who specializes in Japanese and international small caps. Thanks for being here.
MAGUIRE: Thanks Thomas, thanks for having me today. Cheers.
Views expressed are those of the speaker(s) and are subject to change. Other teams may hold different views and make different investment decisions. For professional/institutional investors only. Your capital may be at risk. Podcast produced February 2023.
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