October 17, 2017—Japan holds general elections on October 22. Polls suggest Prime Minister Shinzo Abe’s Liberal Democratic Party (LDP) will secure its current large majority of seats.
Abe’s personal popularity has sagged due to family and cabinet scandals. Nevertheless, voters welcome an improving local economy and support his plans to strengthen the armed forces and increase education and childcare spending.
Through various initiatives, Abe’s government has fostered an “equity culture” supportive of both institutional and individual investors. The government has influenced investors to reduce their portfolio allocations to Japanese government bonds and increase their allocations to equities. We expect these initiatives to step up with Abe’s reelection. We therefore have conviction that Abe’s reelection will be constructive for Japanese equities and anticipate:
- Further reduction of the main corporate tax rate, which has already been slashed from 40% to 30%. These tax rate reductions have freed up cash flow for capital investment, share buybacks, and dividend payout.
- Pressure on listed companies to implement the Corporate Governance Code, formulated by the Tokyo Stock Exchange. The code aims to protect shareholders by requiring companies to include multiple independent directors on their boards, issue minutes of board decisions, and publish detailed financial statements, among other regulations.
- Increased emphasis placed on firms to boost profitability, including shaming companies that fail to achieve the government’s informal 5% minimum return on equity (ROE) standard. We expect Institutional Investor Services (IIS) will, as pledged, recommend that shareholders vote to fire executives of such companies. We also expect that the government will raise the ROE standard.
- Sense of urgency placed on fund managers to implement the Stewardship Code, which requires them to actively engage corporate management to advance the interests of their fund shareholders, including attainment of higher ROE and implementation of stronger governance.
- Direction given to government pension funds to increase allocations to ETFs and mutual funds benched to the JPX-Nikkei 400, an index whose constituents are stocks with the highest ROE and strongest corporate governance.
Japan has the largest market capitalization weight in the MSCI EAFE Index
Given the above, we expect Japan’s companies will exercise increasing degrees of discipline in their capital allocations. They will be less likely to pass up ROE-accretive capital investment opportunities. Also, they will return larger amounts of surplus cash to shareholders through dividend payouts and share buybacks.
Synchronized economic growth across Asia, North America, and Europe is boosting the sales of Japan’s globe-spanning companies. Prospects of modest local inflation bode well for the revenues of companies selling locally. Further, the prospect of a weaker yen may boost revenues of firms that export from Japan. Abe government efforts to construct an equity culture aim to convert the revenues of Japan’s corporations into greater shareholder returns.
The dawn of the equity culture enhances an already-constructive Japanese investment environment. Japanese firms benefit from being domiciled in a country with social tranquility, political stability, and a strong military alliance with the United States. The only potential wild card is an improbable regional military conflict, whose impact would be felt across equities globally, not only those of Japan.
Japanese equities constitute the largest single country share of the MSCI EAFE Index, the benchmark for measuring the performance of approximately 20 developed equity markets, excluding those of the United States and Canada. Our constructive view of Japanese equities supports our overweight to international developed equities.
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