The Japanese equity story is a remarkable one. In the late 1980ies, Japan experienced an asset bubble of epic proportion and almost 30 years later equities are still trading 40–50% below its all-time-highs in Dec 1989. Japanese society was deeply affected by the sheer size in terms of amount of money involved as well as people impacted. In the first half of the 1980ies, the Nikkei 225 appreciated 75%, 12% p.a. and in the second half of the same decade the Nikkei 225 rose another 224% from Jan 1985 to Dec 1989, a staggering 27% p.a. In total, 20% p.a. for a decade.
Excessive money supply and rampant credit growth preceded the asset bubble. Easy money not only lifted equity prices, but also real estate and land prices as well as collectables; amongst which well publicized trophy assets such as Pebble Beach, Van Gogh’s sunflowers and Rockefeller Center. In 1991, Japan’s nationwide land value was worth four times that of all land in the US, a country nearly 25 times larger than Japan.
Commercial land price in the six major cities rose 3x in the period 1985 -1991, residential and industrial land rose 50% in the same period. Eventually, the boom period of over-investment with borrowed money led to its own demise, and it took more than 20 years for the massive imbalances to adjust in the ‘gradual’, ‘socially acceptable’ Japanese way.
Fast forward to 2011
Japan lost its pride; a nation in existential crisis. After 20+years of asset price deflation, the banking system has been restructured and bad loans were cleaned up. No more defaulting loans and no appetite for neither lending nor borrowing. Hurt by falling asset prices Japanese consumers retrenched to repair private balance sheets. With high savings rates and a conservative approach to risk taking by individual as well companies, the outcome was anemic GDP growth. Exports, seen as the only growth opportunity, resulted in a high current account surplus, and in combination with high real rates compared to the US and Europe, the Japanese Yen continued its relentless appreciation. The strong Yen put further pressure on corporate profits and sustained deflationary forces.
The Great East Japan earthquake in March 2011 and the tragedy of Fukushima changed the entire equation. For one, the current account flipped upside down as Japan shut its nuclear power plant and needed to import energy and the public opinion drastically shifted towards a ‘change agenda’.
Deflation at work
For the employed, embedded in the seniority system, deflation was a great thing to have. Corporate management teams, being life-time employed salary men, built massive cash piles to avoid bankruptcies and to safeguard their and employees’ salaries and pensions. As long as consumer goods prices declined, labor enjoyed real wage gains and Japan Inc.’s shareholders footed the bill with low returns on invested capital.
However, an increasingly vast number of younger labor market participants were left out, part timers with no social benefits and no pension entitlement. This younger generation had much lower starting salaries and was deprived of job opportunities and an inability to explore and enhance their skill set by climbing the no-more existent corporate ladders.
The baby boomers saw their kids opportunity set diminish. At the same time, the echo-boomers, Generation Y, finally gained societal influence and change was a matter of time. In 2011, the Bank of Japan (BOJ) re-initiated, with much hesitation, its zero interest rate policy in combination with QE.
The social pain of the earthquake in combination with the ECB’s and US FED’s currency devaluation efforts forced the BOJ’s and Ministry of Finance’s (MOF) hand. The tipping point was reached. Abe-san, after having failed once as prime minister in 2006–2007, understood the change in zeitgeist and with very skilled marketing (his famous three arrows) won with a landslide and Japan went all in to kill ‘deflation’ for good. No holding back, no way back, Japan wanted to close this chapter in its history books.
Tipping Point — Corporate Governance
Most market participants focus on the politics, fiscal policy and monetary intervention, however the most significant and lasting change is introduction of ‘the corporate governance code’. Up until the 80ies, early 90ies Japan was run as controlled state capitalism. The MOF with its bureaucrats acted as central planners controlling the vast Keiretsus and Japan’s banking system. This was an effective model, for a capital investment driven and export led economy. The equity market for that matter was purely for the show. Investors were playing quotations and stock prices were moving up and down, but ‘external’ investors had no voice or influence. Due to tight cross-shareholding external shareholders were excluded from any form of decision making process. Equity holders were ignored, dismissed and hated. On the other hand, lenders were quite influential. Family owned businesses were listed for tax purposes, run by wealthy families for its families. The vast majority of listed companies, the conglomerates, were run by salary men acutely aware of their social responsibility to provide work for the Japanese population.
Real meaningful change
This has all changed. No it is not different this time. It had to change and it changed. Japan often being referred to as a demographic time bomb is enjoying an unexpected benefit. Millions of Japanese retire annually and the labor market is tightest since the 1970ies. Japanese corporates started to embrace efficient human resource allocation because they had to. Yes, labor will become more expensive, but aggregated demand will benefit as an entire generation at lower wages has plenty of pent-up demand combined with a higher propensity to spend. The Abe cabinet is fully aware of it and plays its card well. With tax incentives for wage increases the labor market is in good shape.
However, the corporate governance revolution is THE major driver of change. Breaking up the old power structures of banks and Keiretsus is the ‘hidden’ game plan. The newly drafted guidelines for independent outside directors, nomination committees, compensation committees and enforcing cross shareholding un-wind will give shareholders the well-deserved power to expose poor financial and operational management. It is happening right now and here. Japan will gradually transition from crony, inefficient capital and human resource allocation to a more rewarding, effective form of Japanese capitalism. Admittedly, this is long term trajectory, but Japanese equities have vast upside, because they are not priced for a structural change in shareholder value generation.