A recent visit to Tokyo for a bi-annual Wigmore Association meeting provided an opportunity to discuss with local experts and other investment professionals, a number of investment related topics: could an ageing economy offer interesting prospects for equity investing; how will the Bank of Japan (BoJ) manage its swollen balance sheet; and if there were investment opportunities would they be best captured by index trackers or active managers?
Japan is at the forefront of economies dealing with ageing populations. According to the World Bank the percentage of non-working age people is 43% of those of working age and is expected to exceed 50% by 2030. This is by the far the highest of the world’s largest economies and compares to 32% in Germany, 22% in the United States and 13% in China. Put another way, in Japan each person of non-working age has 2.3 people to support them versus 4.5 in the United States.
Whilst the link between demographics, economic performance and asset class returns has not been tested empirically, there is a supposition that ageing economies result in lower productivity gains, suppressing investment returns on capital.
Hence for many years Sandaire had little exposure to financial assets in Japan. Following the election of Prime Minister Abe for a second time in 2012 with a programme of structural reform, analysts have been watching Japan to see whether the adversity of ageing demographics can be countered.
Prime Minister Abe’s structural reform programme, now in its fifth year, has three parts (dubbed three arrows). The first two have been underway for some time – monetary easing and robust fiscal easing. The third part of the programme is the reform of the private sector, which incorporates a swathe of objectives such as lowering corporate tax and regulatory barriers, boosting labour participation and opening up Japan to foreign workers. Many would see the third arrow as the most important, as it tackles the demographic issue head on. Immigration from other Asian countries into Japan has been increasing but despite some rather glossy reports on this increase, foreign residents are approximately only 1.75% of the population. Increasing the supply of foreign workers remains a slow process, and without increased foreign workers, raising Japan’s potential growth rate becomes very difficult. It is worth noting that according to Fearon’s analysis, Japan comes 157th out of 159 countries in terms of ethnic diversity. Only South Korea and North Korea have less diversified societies.
Can Technology Provide the Answer?
Japan is a world leader in the use of robotics in manufacturing processes. Nachi Robotics of Japan developed the first servo gun technology robot for spot welding in 1979, and it is generally accepted that use of robotics accounted for Japan’s rise as the fourth largest exporting nation in 2017.
Given this backdrop I was hoping to hear about Japan’s use of artificial intelligence and digital based technology as a possible solution to a declining workforce. There was some amusement amongst the group when one of our invited speakers informed us of his investments in Silicon Valley based tech companies!
Despite what appears to be an obvious opportunity, Japan’s venture capital industry remains relatively underdeveloped – although the trend is improving. According to Tokyo-based Venture Enterprise Centre (VEC), such investment totalled just 130.2 billion yen in fiscal 2015, or less than 2% of that in the U.S. Notwithstanding government efforts and the sharp trend towards venture capital in other industrial economies, it appears to be challenging to change a work culture based on ‘cradle to grave’ lifetime employment practices. The slow uptake possibly goes hand-in hand with an ageing population too.
The structural reform programme is also aimed at changing corporate behaviour, with focus on increasing return on capital and better corporate governance. For shareholders, these are welcome developments but do little to raise potential growth.
There has been recent speculation about the BoJ’s conduct of monetary policy. As in the US, Europe and the UK, the BoJ has been engaged in quantitative easing, in an attempt to stimulate economic growth, by purchasing Japanese bonds issued by the government and other securities, such as Japanese equities via the purchase of exchange traded funds (ETFs). This has resulted in an astonishingly steep rise in the size of the BoJ’s balance sheet to over 70% of GDP from less than 20% in 2008.
The most recent innovation in the BoJ’s efforts to banish the economy’s stubborn deflation has been the explicit targeting of a 0% yield on the 10-year Japanese government bond. This nuance to the BoJ’s QE policy initially caused some confusion amongst investors, who were surprised that this new policy actually required less rather than more purchases of bonds. However, it demonstrates the effectiveness of a clear message, and investors have subsequently realised that the BoJ’s policy stance remains ultra loose. Indeed, my understanding of the Bank’s monetary policy going forward is that they are content to remain slightly behind the inflation curve, which is somewhat unusual for a Central Bank. However, even though inflation is edging up, I don’t expect the BoJ will have too many problems with inflation given the profound structural challenges, such as the extreme demographic profile, that confront the economy.
On the matter of the BoJ balance sheet, we see this as an inter-government transfer between the Ministry of Finance and the Bank of Japan: BoJ buys bonds and lends cash. The Ministry of Finance pays the interest on the bonds to BoJ and the coupon payments are returned to the Ministry of Finance as profits. Seen in this light the need for the BoJ to shrink its balance sheet is far from urgent.
Japan is a wonderful country to visit. Despite its density of population and construction, it is an amazingly clean country, where the politeness of people leaves a strong impression. To the casual visitor you would never know that Japan has spent twenty years recovering from the bursting of the stock market and land price bubble. However, the falling population is causing problems in rural areas. I believe the real challenge facing Japan is to integrate a larger proportion of foreign workers, stimulate rural areas, and at the same time, maintain Japan’s uniquely neat cohesive society.
Active or Passive?
If investment opportunities are borne of the need to change, then there should be plenty in Japan. However, in stark contrast to the strong trend of investors flocking to tracker funds, which passively follow the general stock market, I think the best opportunities may result from an ability to pick those companies that are changing. The economics suggest that acceleration in overall economic activity will not be the main driver of future stock returns.