Having underperformed global developed equity markets by nearly nine percentage points in 2012, and having produced among the weakest rates of economic growth in the developed world for much longer than that, Japan has returned to prominence in recent weeks as a result of shifts in the political and economic policy fronts (data: Bloomberg). Specifically, the election of Shinz┼Ź Abe and the return to power of his Liberal Democratic Party have brought fresh optimism to the prospect of fundamental change emphasizing the need to pursue a more expansionist monetary policy. The new government hopes to reverse the appreciation of the yen and to end years of chronic deflation. If successful, this has the potential to drive substantial change within the economy and to materially improve the competitive prospects for many Japanese companies.

We would note the following:

  • Weakening of the yen could provide considerable competitive advantage to the country’s exporters. Chief beneficiaries may include sectors such as industrials, consumer discretionary, and technology.
  • The reversal of chronic deflation could be accompanied by renewed expansion of bank loans as well as lending spreads with strong implications for banks, insurers, and the chronically weak real estate market.
  • These conditions may underpin a structural improvement in nominal growth and profitability across the economy.
  • Coupled with weak market expectations and price-to-book valuations that are among the lowest in the developed world, these improvements could drive significant equity market strength (Data: MSCI).

We would also, however, note the following caveats amid this potentially more constructive country outlook:

  • Japanese demographic trends — weak birth rates along with an aging population — limit the country’s potential to grow.
  • The Japanese fiscal picture is sobering, at best, with a primary budget deficit of 9% of gross domestic product (GDP) — a measure of all goods and services produced in the country — and an overall government debt-to-GDP ratio higher than 200% (Deficit data: ISI Group; Debt-to-GDP ratio data: MSCI).
  • Japan’s low valuation on book value has been accompanied by chronically weak profitability. To the extent that this condition remains linked to poor corporate governance, it will likely remain a drag on the country’s performance.

In sum, while we take no position on the ultimate prospects for success of the government’s initiatives, we remain alert to the opportunities that such changes may represent to strong companies with favorable valuations within our value universe. As always, we believe that a successful company will succeed on the strength of its management, the competitiveness of its productive asset base, the quality of its balance sheet, and the structure of its global market positioning. The location of the company’s domicile is less important to us than its real underlying risk exposures.

Ned Gray manages the Global and International Value Equity strategies and has worked with the investment team for more than 20 years. Prior to joining Delaware Investments in June 2005 in his current position, Gray worked with the team as a portfolio manager at Arborway Capital and Thomas Weisel Partners.