Kate Lin: Welcome to Morningstar. The Bank of Japan is one of the very few central banks that maintain ultra-loose monetary policies. And now inflation in Japan appears to be stickier, which in theory could indicate the potential for the central bank to change policy direction. How might these macro and policy shifts translate into investment opportunities for an asset class that has been winning for the past year?
BoJ's Latest Moves
We’re talking to Oliver Lee. He is a client portfolio manager at Eastspring Investments, who is a value investor in Japanese equities. Oliver, thank you for joining us today. First with the latest moves of the BoJ, where do you think the policies might head in the coming months?
Oliver Lee: Yeah, we’re bottom-up equity investors, so it’s difficult for us to forecast accurately what’s going to happen at a macro level. The timing and sort of magnitude of changes of central banks is notoriously difficult to predict with any accuracy.
Our view over the mid- to long-term is that the Bank of Japan is going to have to tighten policy and that’s going to come in a few stages. I think initially the wording and guidance from Ueda, who’s the Governor of the Bank of Japan, will probably change. That could happen as soon as the October or December meetings this year. And then as we head into 2024, I think you’ll see some further tweaks, if not the ending of yield curve control. And then the final stage will be a removal of the negative interest rate policy that’s been in place for many years.
It’s funny because those two policies are abnormal policy, which were put in place for abnormal times. So we, as an equity investor, would welcome some degree of normalization of monetary policy. But I appreciate it’s going to take some time. I do think that’s going to happen though inflationary pressure is building in Japan. For the last 17 months, inflation has been above the Bank of Japan’s 2% target. I have some sympathy with the fact that maybe they’re letting the market run a bit hot, but even core core inflation now excluding energy and food, is still 3%. So I think they will have to tighten policy sooner rather than later. The key thing they’re looking for is sustainable wage growth. We’ve seen that this year in our conversations with CEOs and CFOs. That is something that’s coming up more frequently. So as we head into next year, I think wage growth pressures will remain, especially as the labor market is quite tight. But just to conclude, we would see a normalization of interest rate policy is a good thing for corporate Japan and a good thing for equity shareholders.
Is a Stronger Yen the Enemy?
Lin: Well, let’s bring the discussion to corporate in Japan. So this year, a key factor behind the strong export performances and earnings in Japan is the weakness in the Japanese yen. So do you think it is likely that will continue into the year of 24 and what is your outlook for next year?
Lee: Yeah, again it’s quite hard for us to actually predict specific levels for the yen-dollar and we’re now at 150 that’s a sort of a 20-year weak level. There’s a 95% correlation with the weakness that we’ve seen in the last 18 months and the interest rate gap with the U.S. Obviously the Fed has tightened rates pretty quickly. The Bank of Japan has remained very dovish. So, yeah, that interest rate yield gap has widened out quite significantly. I would expect that if consensus is correct, in the second half of next year, you’ll see the Fed start to potentially loosen rates.
As I said in my prior answer, I do expect the direction of travel for the Bank of Japan to be a little bit tighter. So that interest rate gap is going to close and therefore it would be logical to conclude that you’re going to start seeing some yen strength. [About] how quickly the yen strengthens from here, it’s very difficult to know. We use an average 120 yen-dollar rate in our model, which is a long-term average. So for all our valuation work we do on stocks, we are going to use a stronger yen than currently priced in in the market. So we’re not scared of a little bit of yen strength. We have over 60% upside to our valuation targets using that stronger level.
I think the knee-jerk reaction if we saw a big move in the yen to become a bit stronger would be a sell-off in some of the auto names, some of the exporters, some of the manufacturers, and potentially a bit of a rally and a bit more of a bid for domestic names, importers, and any company which actually is reliance on overseas raw materials. And so there will be some moves in the market once we see our currency start to change. I don’t expect any intervention in the near term from the Bank of Japan. They’ve tried it before. It often just slows rather than stems the decline. But if we do move towards 155 or 160 potentially that is a pain point where the Bank of Japan would consider intervening again. So, yeah, I’ll I’ll leave my answer there for the yen.
Will There Be a Further Upside?
Lin: Yeah, of course. Thanks to a weak yen and among other factors, Japanese equities have been among the top performers this year. So do you think there is more room for upside in the broad market and how are you picking Japanese value stock winners in this hot market?
Lee: Yeah, maybe just following on from the last question, a lot of people expect that a stronger yen is bad for Japanese equities, but our view is that the long-term structural investment case is very much intact.
Most investors I talked to remain underweight Japanese equities in their portfolios and are looking to close that underweight. The three structural tailwinds for Japanese equities are number 1: A move from deflation towards an inflationary environment and number 2 is better corporate governance practices which is leading to potentially better economic profitability for companies. And then thirdly, the capital expenditure environment is quite strong at the moment and that’s changed compared to the last 20 or 30 years and it’s driven by reshoring, friend-shoring, and the green transition. So there are a number of drivers which I think are there.
So even if the global economy took a downturn and Japanese equities were a little bit soft, I think a lot of people would use that as an entry point as an opportunity to continue to build their strategic stakes in Japanese equities.
And we continue to find good areas to invest in. We’re contrarian investors and that means we have a sort of value style to how we invest. We’re overweight autos and financials, although less so than we were earlier in the year. We’ve taken profit as some of those stocks have moved closer to our price targets and we’ve rotated that capital into domestic names, into defensives, and more recently into chemical names which have been a real laggard area of the market on weakness around demand and pricing. And so, we still find plenty of opportunities.
Valuations have come up quite a lot recently with investors. We’re probably at or around the long-term sort of averages for Japan at an index level now. So, on a P/E basis, yeah, we’re at that level, and on a price-to-book basis, we’re probably slightly above. But Japan equities still are much cheaper than Europe, much cheaper than the U.S. And I think there’s good value for international investors as they start to reallocate to Japanese equities.
Lin: Amazing. Thank you so much for your time, Oliver. For Morningstar, I’m Kate Lin.
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