3 Reasons to Avoid Long-Term Investments in Japan
The investment picture in the world's third largest economy is far from clear. Economic growth in Japan over the last 20+ years has been sluggish at best and non-existent at worst: Japan has averaged an anemic 0.49% GDP growth rate since 1980. Last year, Japan entered its sixth recession since 1994 with the economy contracting 1.9% in Q2 and another 0.5% in Q3 (the US has only had two recessions over the same period).
The inflation problem in Japan is arguably worse. While Japanese markets have largely cheered Bank of Japan (BoJ) Governor Haruhiko Kuroda's “qualitative and quantitative easing” [QQE] programs launched in April 2013, the actual economic results have been disappointing. Kuroda set out to reach an inflation target of 2% in two years, but here we are in 2015 and the BoJ has just lowered its core inflation projection to 1% for the fiscal year starting in April. For all its fanfare, the installation of QQE has doubled Japan's monetary base, but the actual broad money supply is hardly moving at all. Read: QQE is not working very well. Still, many analysts are bullish on Japan as Japanese stocks trade at about half the price-to-book ratio of US stocks and Japanese P/Es are significantly below their 10-year averages; this makes them some of the most attractive valuations in the world. What's more, corporate earnings in Japan have risen faster than share prices over the last year, so Japanese equities arguably have room to run from a pure earnings standpoint without the need for multiple expansions. The bullish case may sound compelling, but I still think you should avoid Japan . And not because of reasons directly related to inflation, growth, or valuations (which I largely view as short term concerns). My reluctance on Japan stems from what I see as deeply rooted structural issues . Unless they are seriously addressed by politicians and Japanese society at large, Japan's ability for sustained and healthy long-term growth could be seriously inhibited. There are three issues I see... 1. Unfavorable Demographics In Japan, people over the age of 65 make up one-quarter of the country's entire population, which is the highest of any country in the world. It follows that Japan's working age population is declining at an alarming rate. A study by Japan's Cabinet Office found that, as a result of low fertility rate and high life expectancy, Japan's working-age population (ages 15 through 64) dipped below 80 million in October 2013 for the first time in 32 years. And, it's expected to get worse (projections indicate that it will fall below 60 million by 2040, creating a labor shortfall of up to 8 million workers). Looking out even further, the government expects that Japan will lose 4 out of every 10 workers by 2060, shaving as much as 0.9% off potential growth - more than half of last year's expansion. To be sure, these workers aren't dying - they're retiring. Which creates a deep and two-pronged structural problem: 1) there aren't enough workers to meet the economy's growing needs, and 2) the costs of caring for the elderly are due to skyrocket over time. If you have fewer workers to support economic growth and the tax base, and if you simultaneously have more retirees in need of social program dollars for necessities like healthcare, you get mounting deficits over time which can paralyze economic growth. 2. Narrow Labor Markets A solution to Japan's unfavorable demographics could come from two places: 1) more women and 2) more immigrants in the workplace. But Japan has not done much to allow for either. Prime Minister Shinzo Abe seemed ready to change the nature and structure of women in the workplace when, in 2012, he called for "Womenomics" to be a top political priority. He even told the U.N. General Assembly that “creating an environment in which women find it comfortable to work is no longer a matter of choice for Japan. It is instead a matter of greatest urgency. Yet between 2003 and 2013, the female labor participation in leading positions only managed to rise from 9.7% to 11.2% and, though Abe has used rhetoric to challenge businesses to promote more women to senior management, there has not been anything to speak of in terms of policy change. Japan is also notorious for its extremely strict immigration policies. Foreign nationals account for only 1.6% of Japan's population, the third lowest proportion behind Poland and Slovakia amongst OECD countries. In the US the rate is 6.8%. The resistance to immigration is largely a cultural issue for Japan (fearing losing their grip on cultural autonomy and deeply rooted traditions). Respectable as those cultural inclinations are, they defy one of the fundamental laws of free market economics that could greatly give Japan the labor boost they need. 3. Too Much Protectionism Japan has a long-standing reputation for high tariffs and barriers to entry, especially in the auto and agriculture industries. But today, there's a glimmer of hope for a structural change in the Trans Pacific Partnership [TPP] - a free trade agreement between Japan, the US, Canada, and nine other Pacific Rim countries. It could be the key to Japan opening up its agricultural sector to overseas competition, which could greatly reduce food prices for Japanese consumers and give a boost to the spending economy. The TPP has met Japanese resistance, however, in large part due to objections over the requirement for Japan to abolish tariffs in its five "sacred" farm products of rice, wheat, sugar, dairy products, and beef and pork. These tariffs have existed for years in Japan and, with rural constituencies representing a decent chunk of parliament, the political pressure is likely too large for Japanese leaders to submit to the terms of the TPP. The 778% tariff on rice imports is likely to stay and Japanese consumers will probably continue to spend a much larger percentage of their household budget on food (14%) versus US (6.3%) and UK (9.3%) consumers. Japan is Focused on the Wrong Policy Today, Japan's politicians and central bankers are focusing most of their policy efforts on inflation and short-term growth concerns, but I think they're ignoring the more important issues facing their economy (addressing the labor market and making their economy more competitive). Bank of Japan Governor Haruhiko Kuroda can keep printing money all day and night, but that is not going to solve Japan's widening labor market issues and it certainly won't help to advance productivity. What will do those things are policy directives that allow for more competition and freer flow of capital, with reductions in tariffs across the board. Until Japan starts making those types of political and structural changes, I'm reluctant to be too optimistic about the Rising Sun. Putting our money where our mouth is, Zacks Investment Management's International Equity Strategy exposure in Japan, 14.18%, is notably less than the EFA benchmark of 21.26% and somewhat less than the ACWX benchmark of 15.10%. Additionally, the International Equity Strategy exposure remains 72% (developed countries) and 28% (emerging countries).
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