Japan: Abenomics enters a decisive stage

“Japanese companies have sufficient justification and financial means to modernize their productive assets.”

Having seen the success of its first two economic stimulus measures, the Abe administration is now trying to pass reforms that aim to completely lift Japan out of its long era of deflation. One immediate goal is to raise business spending – a prospect that bodes well for Japanese equities.

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Toru Ibayashi
Head, UBS CIO Wealth Management, Research Japan

Since Shinzo Abe reclaimed his post as Japanese Prime Minister last December, his economic revival plan – a ‘three arrow’ program popularly known as Abenomics – has been a boon to the equity market. The program has attracted more than JPY 10 trillion in foreign investment and boosted the Nikkei 225 index from less than 9,000 last year to around 15,500 in November.

Despite these advances, Abenomics still has a lot to prove, and investors remain skeptical of its impact to the real economy. So far, Abe’s first two arrows have worked as envisaged: the fiscal stimulus increased private consumption and public spending, while the monetary stimulus weakened the yen and supported exports. But while these measures have helped Japan’s GDP expand continuously in the last three quarters, much thanks is due to the yen and higher asset prices.

For such a pace of growth to last for the long term, Japan needs private companies to consistently raise spending on productive physical assets. From April to June, for example, business capital expenditure, or capex, grew 1.4% from a year ago, but this came after three consecutive quarters of decline.

Core to the third arrow of Abenomics is to make higher capex a lasting trend. The government’s ‘new growth strategy’ – much of which will need legislative approval – includes more than 100 areas of deregulation and ways to promote Japanese enterprises, through more relaxed business rules and perhaps even lower tax rates. Essentially, it aims to provide incentives for companies to put their capital to good use and, thus, engender Japan’s capex revival.

Reasonable expectations

The good news is that the government may not have such a hard time convincing Japanese companies to spend. First, existing equipment are aging. A government survey estimates the average age of Japanese manufacturers’ production equipment at 16 years, or 3–4 years more than those of American and German counterparts. Introducing tax incentives, subsidies, or a higher depreciation rate would stimulate a new replacement cycle, in our view.

Second, Japanese companies can afford to invest. Current levels of cash at hand are historically high, and debt-to-equity ratios historically low. Furthermore, balance sheets and profitability have improved dramatically in recent quarters, giving companies more investment firepower.

Third, new regulations may actually induce capital spending. The governmentis considering imposing more stringent requirements for earthquake-resistant buildings and energy-efficient equipment, and penalizing companies that fall short of the required conditions. This would push companies to invest in new capital assets.

Finally, Japan’s working population is declining. With its fast-aging society and the approaching retirement of ‘baby boomers,’ Japan will lose 6.3% of its working population in the next five years. The weaker yen may encourage Japanese companies to bring some offshore production back home, but they will likely find fewer available workers, increasing their reliance on more productive technologies.

In short, we believe Japanese companies have sufficient justification and financial wherewithal to modernize their buildings and factories, IT systems, production equipment and facilities, and other aging assets.

Investment opportunities

If a Japanese capex revival does take hold, investment opportunities are likely to emerge in directly related sectors. The primary ones would be the construction, heavy industry, and machinery sectors, which are best positioned for the potential replacement cycle for capital assets over the next 2–3 years. This will be on top of the business they already generate from the public investment driven by the government’s fiscal measures.

Furthermore, many of Japan’s capital equipment makers have meaningful exposure to Europe and the emerging markets. So far, this has worked as a ‘discount factor’ to their share prices because these regions are facing growth constraints. Over the next year, we believe the recovering European and emerging market economies will turn into a support factor for capitalequipment manufacturers.

The sectors mentioned above are considered ‘late cyclical,’ which means their earnings tend to accelerate in the middle of an economic recovery cycle. As such, during this period, these sectors will be more likely to outperform the benchmark compared to other sectors.

The IT sector is also poised to capture the benefits of a capex revival. With their high levels of cash and earnings, Japanese companies have sufficiently deep pockets to upgrade their IT systems as well as other assets. In our view, IT investment has become crucial for Japanese companies to sustain productivity, given the accelerating decline of the local workforce.

One way companies can accommodate this demographic shift is by enabling remote working environments. Recent developments in secure data transmission and communication facilitate work-from-home arrangements. The consumption tax hike starting April 2014 should already be serving as a catalyst for many companies to modernize their IT systems.

Finally, energy will play a crucial role in Japan’s capex revival. The country has lost more than 20% of its power generation capacity since the 2011 earthquake and tsunami shut down its nuclear power plants. With its existing geothermal facilities being old and inefficient, Japan needs to prioritize the buildup of more efficient thermal power plants.

To realize his capex revival vision, Abe needs to cross legislative hurdles. With his Liberal Democratic Party controlling both houses of the Diet, Abe may well see his key reform bills pass next year, assuming he does nothing to damage his popularity. As the third arrow of Abenomics comes into shape, other potential investment opportunities could well emerge.

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The views in this article were expressed on 29 November 2013. For the latest views from UBS Chief Investment Office Research, please contact your Client Advisor.