Equity Outlook  |  Q1 2018

Japan: Progress and problems

Jeffrey B. Sacknowitz, CFA

Jeffrey B. Sacknowitz, CFA
Portfolio Manager of Putnam International Growth Fund

  • The long-term outlook for Japan is clouded by a combination of high national debt, an aging population, and a rapidly shrinking workforce.
  • We see many near-term opportunities in a business environment that is evolving in positive ways.
  • Companies are beginning to improve their profitability and capital efficiency, and returns on equity are rising rapidly as they shed bad assets and cut costs.

Japan is a study in contrasts. In the near term, I see improving business profitability, increasing attempts at innovation, and many compelling investment choices. Over the longer term, however, my outlook for Japanese equities is considerably less optimistic — clouded by looming macroeconomic difficulties.

Debt grows while population shrinks

Let's discuss the cautionary tale first. Over the longer term, the combination of Japan's high debt level, aging population, and rapidly shrinking workforce gives me cause for serious concern. Japan's national debt has risen steadily and sharply for 25 years, with today's debt-to-GDP ratio in the range of 250%. Even in an economy with a growing population, this debt level would represent a massive burden. With the added strains of Japan's increasing elderly population and fewer workers to support the retirees and the debt, that burden becomes unsustainable, in my view.

Since almost all of Japan's debt is held internally, the problem has been allowed to endure and worsen over time. This differs from a more traditional "external debt crisis," which tends to come to a more ugly, but rapid conclusion. The "internal" nature of the debt burden also makes it much more difficult to predict when this will likely become a crisis for the Japanese economy, what might trigger it, and the extent of the damage it could cause for financial markets. From our perspective as investment managers, we are constantly on alert, actively managing and positioning our portfolios to focus on companies that would be less vulnerable to this potential debt debacle. Given signs of an improving economy, combined with ultra-low interest rates, the immediate risks of a crisis are low.

Dynamic and profitable: A healthy shift for Japanese businesses

While the long-term macroeconomic risks are top-of-mind, we also see many opportunities in a business environment that is evolving in positive ways. For many decades, Japanese companies have been poorly managed. They were unwilling or unable to innovate, to shed unprofitable businesses that were no longer strategic, or to disrupt their conservative, conglomerate-style business models. The result has been extremely low returns on investment in Japan. However, since Prime Minister Shinzo Abe took office in December 2012, the Japanese government has taken a series of steps to encourage businesses to focus more on profit generation and balance sheet management, and to remove at least some of the negative stigma associated with companies shedding underperforming business lines.

While the changes have been slow to take hold, we are starting to see signs that some companies are improving their profitability and capital efficiency. Their returns on equity are rising rapidly as they shed bad assets and cut costs. We are also witnessing the growth of a new generation of business leaders and company managers who came of age during the economic "lost quarter-century" in Japan. Many of these new leaders are professionally trained in management and tend to be more dynamic and more willing to make difficult business decisions.

With this, we are seeing rapidly rising profits for many Japanese businesses, which has led to significantly better overall returns on equity and returns on investment, albeit still at lower levels than those of other advanced countries. As these more efficiently managed companies begin to use their healthier cash flows and growing profits to generate better returns for shareholders, it should lead to more attractive investment opportunities for us.

Current price to earnings is a ratio equal to the market capitalization divided by its after-tax earnings, based on 12 months' trailing earnings. Current price to book is a ratio of a fund's capitalization divided by its book value. Return on equity (ROE) is a measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested.

The Euro STOXX 50 Index is a market capitalization weighted stock index of large, blue-chip European companies. Components are selected from the Euro STOXX Index. The Japan TOPIX Index is a free-float market capitalization-weighted index that is calculated based on all the domestic common stocks listed on the TSE First Section.

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