NAV and Manager’s Report

March 2018

The first quarter of 2018 has been positive for the man in the street with labour markets tighter, improved consumer confidence and companies producing solid profits but this stands in contrast with a distinctly sour mood in equity markets. In the scheme of bad starts to the year, 2018’s has by no means been especially bad, but most developed markets are down 5% or thereabouts and the Wall of Worry seems to have grown a line of bricks higher. Irrational exuberance it is not.

Just as July 2016 marked a bottom in sovereign bond yields, so too it marked a shift in equity market leadership from growth to value. The relief for value investors – especially so in Japan – was enormous, as value had been murdered in the Japanese equity market in the years following the financial meltdown of 2008. The galling aspect was that the sectors that led the market in the period from 2009 to mid-2016 were hardly growth in the sense one normally associates with the word. Food stocks, pharmaceuticals, railways and domestic construction are not sectors with glowing growth prospects, but while they might not have offered earnings growth to any real extent, they did offer less volatility in revenue and earnings, and this quality was deemed sufficient in a world where sovereign bond yields, nominal or real, were vanishing. Once bond yields began to rise however, equity investors cast their eyes into long overlooked sectors with downtrodden valuations and value led the market recovery through to the end of 2017.

We – being optimistic on the positive changes taking place in Japan’s economy and in management attitudes – welcomed the collective lift in expectations, but the first quarter this year has seen more similarities with the “growth” ice age than we would like. While the Topix index was down 5.6% (JPY) in the quarter the more cyclical sectors were punished with steel (-18%), shipping (-17%) and non-ferrous metals, glass, rubber and banks all down by double digits. Only three Topix sectors were up in the quarter with Other Products (Nintendo), Pharma and Electric Power and Gas all showing small gains. J REITS, which admittedly had fallen to levels that have begun making sense to a value investor, also rose.

We wrote in last month’s letter about the Yen/$ rate and the rise of the Yen against the dollar in 2018. Even for a visitor to Japan coming from Australia – with its relatively weak currency – Japan does not feel expensive. When looking at the Yen exchange rate, it is inevitably measured against the US dollar, but if one looks at the Yen using other measures, the strong Yen story does not stack up. The chart below is the JP Morgan Japan Real Effective Exchange Rate (REER) which – if I understand it – adjusts the exchange rate for changes in the CPI of Japan against changes in the CPIs of a basket of countries and reaches a very different conclusion. The current Yen level is as low as it has been over the past 20 years, and would partly explain why the profitability of Japan’s companies has not been hurt to any extent by the strength of the Yen against the USD since mid-2015.

JP Morgan’s Japan REER (20 years)

Shorter term, we think it is quite likely that the Yen weakens somewhat, but there are certainly good grounds to think that over the longer term, the Yen might trend higher. There is a tendency to think of a weaker currency as a corollary of an aging, declining population but a tourist in Japan from any developed country would be surprised at how cheap many goods and services are. Where the Yen goes is an argument for others – though even then very few currency prognosticators are ever held to account – but the clearest message for us is not to judge the strength of the Yen by the USD/JPY exchange rate. Take a trip to Japan and see what you think. A personal, hands-on assessment – a variation of the Economist magazine’s Big Mac Index – is more likely to help you form a view of the Yen’s over/under valuation than interest rate differentials, current account surpluses, or, if you must, patterns on the chart.

We are relieved to enter April and leave Q1 2018 behind. In our portfolio, the losers outnumbered the winners with significant drags on the Fund’s return from Mitsubishi UFJ, Kasai Kogyo, Mitsui OSK, Nippon Steel and Hitachi. Countering these to some extent were domestic names Hazama Ando, Sekisui House, Izumi and S Foods, but all in all, we enter a new quarter, and a new financial year in Japan, with continued confidence in our portfolio’s holdings and the outlook for Japan.