With US tariffs already in effect for the aluminum and steel exports, the Trump administration has intimated that the automobile industry could be next. Investors' concerns are legitimate given that the US is the biggest market for Japanese carmakers. Japan, however, is not alone. The table below (Fig 1) indicates the potential GDP effects on the countries should the US unilaterally proceed with the tariffs. In absolute terms, Germany’s GDP would take the biggest hit followed by Japan, but on a percentage basis, the impact on Japan is much lower than Canada, Germany and South Korea.

Fig 1 : Effects of unilateral US Import Tariffs*2

Invest in japan -1

So why is Japan unloved?

Japan cannot seem to shake off its deflationary stupor. The country has been mired in low growth since the 1980s and its rapidly ageing population continues to keep the lid on domestic consumer spending despite the ample stimulus measures. That Bank of Japan has chosen to maintain its ultra loose monetary policy in its latest meeting, albeit some tweaks in a bid for more flexibility, is proof their inflation goal of 2% is nowhere within reach.

As a result, the burden has fallen onto Japan Inc to deliver strong earnings. And they have following years of restructuring. Japan’s earnings per share (EPS) growth has outpaced EPS growth in other developed markets. Beyond profits, on a trend basis, company leverage has fallen materially; production capacity has tightened, whilst non-financial companies' return on assets has risen to converge with global peers (see Fig 2).

Fig 2: Corporate Japan is in very good shape3

It is therefore not surprising that any impact on corporate profits (such as US tariffs) will likely be viewed negatively. But are the fears justified?

In truth, Japanese automakers are in a better position to weather the tariffs since they produce more autos in the US than they import. The Japan / US “car wars” in the 1980s resulted in increased Japanese production in the US; 75% of the “Big 3” auto production is now outside of Japan. In 2017, 3.8 million vehicle units were produced in their US factories whilst only 1.7 million were imported4. Still, 1.7 million is not an insignificant number with respect to earnings. But to purely focus on earnings suggests an overreaction as one also needs to assess the financial strength, price and valuation of the individual auto manufacturers to arrive at a balanced view.

Furthermore, Japan’s automakers have alternative export destinations should tariffs affect their US sales. For a start, they stand to benefit from China’s auto tariff reduction from 25% to 15%, especially since China is now the largest auto market in the world. In addition, the EU-Japan Economic Partnership Agreement is the largest bilateral free trade agreement eliminating 99 percent of tariffs on Japanese imports by the EU.

Skeptics will likely want more proof after the latest June quarter Bank of Japan’s Tankan survey showed a dip in business confidence compared to the March quarter. The same survey however did reveal that large corporates expect a sharp rise of 13.6 percent in capital spending in the current financial year ending March 2019 versus the 2.3 percent forecast in the previous survey.

This marked rise in spending is a result of the tight labour market conditions which has kept the unemployment rate at multi-decade lows and the job-offer-to-applicant ratio of 1.65 at the highest since 1974; it is inevitable that new investments in productivity-enhancing equipment and factory automation will have to accelerate to offset worker shortages.

Artificial Intelligence (A.I.) to rewrite Japan’s future

Unlike in the 1982 Extraterrestrial movie in which “E.T. goes home”, A.I. is here to stay. Worldwide spending on A.I.systems is forecast to achieve a compound annual growth rate (CAGR) of 50.1% over the 2016-2021 forecast period6.

In Japan too, the amount spent is being boosted under the Fifth Science and Technology Basic Plan, a ¥26 trillion government-backed investment in A.I. research that runs from 2016 to 20207. The 2018 A.I. budget8 shows a 30 percent jump from 2017 with the focus on the development of A.I. chips for next generation computers and robotics, an area in which Japan is a clear leader.

Japan is the world’s biggest industrial robot maker and the vast streams of data generated by thousands of robots on Japan’s factory lines can be used for deep learning to make these robots more intelligent. This is Japan’s niche; intelligence in machines will change the face of the robotics industry. Thinking robots will be able to conduct a task much faster leading to higher automation and productivity levels.

According to a 2017 Price Waterhouse Coopers report, A.I. will push global GDP higher by 14 percent in 2030, which would be an equivalent of an additional $15.7 trillion. Improved labour productivity is expected to make up for over half of all economic gains from A.I. between 2016 and 2030. Separately, if the forecasts in Fig 3 pan out, then productivity levels in Japan have bottomed and expected to overtake the US by the second quarter of 2019.

A.I. will benefit countries with ageing populations and labour shortages. As one of the first to be hit by the silver tsunami wave, Japan could lead the way in using new technologies to reinvent its society.

Fig 3 : Productivity Trend - Japan versus the United States9

Japan offers attractive bargains

Corporate Japan is in pretty good shape; the corporate picture is significantly better than the headlines and sluggish economic activity suggest. Corporate earnings have been strong and consistently delivered above the forecasts since the third quarter of 2017. Valuations have also remained at attractive levels since 2010 and the upside potential compensates for the apparent risks (see Fig 4).

Fig 4: Japan's valuations remain in attractive territory10

Despite this, investor skepticism remains deeply ingrained in the face of economic and trade uncertainties, with many choosing to value the market on perception rather than reality. Equally, for the discerning investor, Japan is worth a closer look especially given the fact that there are a number of great companies going for a bargain.

At Eastspring Investments, we continue to identify excellent stock buying opportunities in the current environment, typically taking advantage of market volatility to accumulate attractively priced equities in our Japan portfolios. In truth, Japan has always been a corporate, not an economic, revival story; it will clearly take time to change those perceptions but when they do change, Japan’s under-valued equities could spring back – fast.


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