GSAM’s Kosuge: Abenomics will deliver but challenges still present

Ichiro Kosuge, GSAM’s head of equity Japan analyses the outlook for the Japanese market in light of Abenomics and reforms under way.

In Japan, markets have been volatile this year up to now due to concerns about emerging markets and China, the impact of consumption tax increase, recent geopolitical events and stretched valuation in some markets and sectors.

Japanese equities have lagged the other developed equity markets for several months, yet we believe there are a number of catalysts on the horizon including: the normalization of spending patterns after the consumption tax, potential for wage increases for the majority of the population, shortage of labor force further pushing wages upwards and the possibility of corporate earnings estimate increases in the second half of the year.

In addition, we expect some amount of fiscal stimulus to be doled out during the supplemental budget this year which should support domestic construction demand and Bank of Japan (“BoJ”) could take further action on monetary easing if they see weaker than expected economic data.

Over the longer term, we expect the third arrow of Abenomics, “Structural reform” to deliver. Japan is globally the most exposed market to capex, which has already been increasing, particularly in machinery and factory automation. Japan’s statutory corporate tax rate, which is one of the highest in the world, was reduced from 38.0% to 35.6% in April.

Prime Minister Shinzo Abe is considering reducing it further to international levels (20%), which should bode well for the industry. And finally, the government is also trying to get public pension funds of Japan, including Government Pension Investment Fund (“GPIF”), to change their asset allocation in favor of equities, which should increase flows into the equity markets over the coming years.

Post the consumption tax hike, while activity subsequently slowed, it still remains ahead of expectations. We believe that companies will likely upgrade their cautious FY14 guidance, if demand and the economy hold up as we expect. We believe the domestic economy in Japan is improving. Equity markets have already started to react positively with the TOPIX returning 3% in May, the highest monthly return for 2014 so far.

We will continue to look for opportunities to invest in stocks with strong intermediate prospects at reasonable valuations and focus on selecting companies that we believe are likely to beat consensus earnings expectations.

We continue to be bullish on construction and real estate sector, given the recovery in the underlying economy and inflation expectations. Accordingly, we initiated a position on a company which provides financial services, brokerage, consulting and other services to the real estate sector.

We like companies that can be a beneficiary of strong domestic demand including consumption demand, demand from construction activities and capital expenditure.

We expect consumer spending to grow consistently as wages increase with reflation and the tightening of the labor market to fuel further wage increases. We initiated a hotel and resorts operator, which we feel should benefit from increasing resort membership and discretionary expenditure which is a play on increase in consumption.

Construction has been active since 2011, when government increased supplementary budget for reconstruction post the earthquake in March 2011. This has been followed by further commitment to public construction spending as a part of Abenomics and in preparation to the Olympics in 2020. We hold a position in a manufacturer of construction and civil engineering products, which we feel should benefit from an increase in construction activities.

We like machinery companies as beneficiary of capex recovery. We think industrial robot demand will be stronger this year because of labor shortage and focus on improving safety at workplaces. Additionally, replacement cycle demand may support Japanese robot producers. We hold a position in a manufacturer of an industrial robot and industrial machinery, in our portfolio as a beneficiary of capex recovery.

In addition to these sectorial themes, we also prefer companies across sectors like IT, e-commerce and industrials that have unique/company specific growth drivers 

Our approach to managing GS Japan Portfolio is bottom up driven by fundamental research. Hence, the beta of the portfolio is generally a by-product of our stock selection and portfolio construction. Currently, the beta of the portfolio is slightly above 1. While it does underscore our bullish view on the market, we would like to highlight that we are selective in the kinds of companies that we have invested in which center around themes like improving domestic consumption, industrial capex recovery, recovering construction activities and possible reflationary economy.

GS Japan Portfolio is an all-cap portfolio and hence, includes all market capitalizations but is focused primarily on large and mid-cap investments. In the present environment, we believe that opportunities in Japan exist across all market cap segments and are open to investing in key ideas as long as we find them suitable for the portfolio. We haven’t changed our philosophy or skewed the portfolio in any one particular direction; rather, we maintain a balanced portfolio of companies that we think would outperform for stock-specific reasons. We have increased our exposure to domestically-oriented companies which fall across the market-cap spectrum.

We would like to highlight three key factors that any Japanese equity manager would have to look out for. Firstly, the slowdown in external demand. Demand in key emerging markets, especially China, might continue to slow down on the backdrop of a slowing economy.

Secondly, the bottleneck in capacity and constraint on human resources. Low capital expenditure over the last 5 years coupled with the current strength in domestic demand might pose some supply constraints in select industries going forward. Similarly, unemployment rate in Japan at 3.6%, as of April is the lowest seen since 2007, which could potentially cause a shortage in labor force in select industries.

Thirdly, fluctuation of Yen versus the US Dollar. Strengthening of US dollar as a result of tapering in the US and weakening of Yen from Abenomics and BoJ policies has benefitted exporters in 2013. Yen has appreciated year to date, we feel it is a risk if Yen appreciates further, especially to those companies which derive a significant portion of their revenues from exports.

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