Talking Heads – Le soleil s'est levé pour les petites capitalisations japonaises

This is an audio transcript of the Talking Heads podcast episode: The sun has risen for Japanese small caps 

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads Podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing Japanese small caps. I’m Daniel Morris, chief market strategist, and I’m joined today by Junki Okamoto, Deputy Portfolio Manager, and Sean Park, Investment Specialist. Welcome and thanks for joining me. 

Sean Park: Hi, Daniel. Thank you for having us. 

DM: One of the many surprises we’ve had this year, it’s safe to say has been the performance of Japanese equities, certainly from the point of view of a lot of investors in Europe and in the US, not a lot of attention has been paid to Japanese equities.  

We appreciate there had been a fairly long period of relative underperformance So certainly with episodes of quite strong outperformance and that’s been the case this year, particularly when we see many other markets struggling now as interest rates are rising and renewed fears of a growth slowdown, at least in the US with US Treasury yields up to 5%, which not so long ago seemed almost an impossible prospect. Yet that’s where we are today.  

So, let’s talk a bit about why we’ve had this rally in Japanese equities, particularly, given that for most people it was relatively unexpected.  

So, Sean, can I turn to you first and get your take on what’s really been going on in the market this year? 

SP: The two points that I want to mention: the positive changes on the macroeconomic side and some changes seen on the Japanese corporate side.  

 Japan has been trapped into the deflation over the past 20 years. And we think that the essential cause is that Japanese companies and Japanese consumers were lacking the idea of passing on costs to retail prices.  

Nowadays, more companies are willing to actually accept such a rise in retail prices and this same phenomenon is seen among consumers.  

Recently, we have seen a gradual acceptance by smaller cap companies.  

If you look at the EPS growth of large-cap and small-cap companies, especially after the COVID 19 pandemic, small-cap companies have been lagging. But we have seen a positive outperformance among small-cap companies from the beginning of the first quarter 2023.  

So, the next question would be how sustainable inflation will be going forward. And we believe that the key factor is wage growth. In fact, we see wage growth of 3.8% this year, which is at the highest level in the past 30 years. This wage growth should stimulate domestic personal consumption in Japan, which will lead to an increase in corporate earnings. And then we could expect more wage growth for the next few quarters.  

DM: Thanks, Sean. You pointed out that clearly the change in the macroeconomic environment, essentially a return of inflation after two decades of deflation, was critical. But then you importantly mentioned that there has been changes at the corporate level.  

So perhaps you can give us a bit more background on that. What have been some of the positive changes you’ve seen on the part of the Japanese corporates? 

JO: We believe that Japan’s now going to transition from deflation to inflation. We believe this trend will continue.  

The first reason is ample cash in Japanese companies, the second reason is positive momentum for wage hikes and capital spending. And the final reason is profitability improvement. 

Japanese companies have improved their profit margins over the past 15 years through corporate efforts such as cost cutting and development of high value-added products, services and so on.  

Japanese companies have generally saved the profit they earned as cash. This means that Japan’s firms have ample room to use their cash more so than companies in other developed countries, for example, the United States, eurozone.  

We believe that the key point to inflation taking hold is whether wage increases, and capital spending will continue. But in this respect, we see that Japanese companies have a lot of room to do so. The main reason [for the wage increases] is a declining population and restructuring of supply chains. To get new workers, companies try to increase their wage levels and use new machine robot and software to improve operational efficiency.  

The second reason is the restructuring of supply chains. A particularly obvious example would be semiconductors. Plants are being built in Kumamoto, Hokkaido and so on. [Looking ahead], we can expect to see excess cash earnings going to investments. We believe that these will be long-term topics in the Japanese market. 

DM: We’ve talked about what supported returns for Japanese equities so far this year. But of course, what matters now is what happens next. We know the weakness of the yen has been a big positive contributor so far. What’s your outlook on the yen now and its impact on Japanese small caps? 

SP: Basically, the reason behind this weaker yen at this moment is the yield spread between Japan and the other countries. Having said that, we don’t expect further depreciation of Japanese yen from the current level. If we see a drastic increase in the import prices, we may face stagflation.  

In Japan, we are seeing that the economy is moving on from deflation. If you take an outlook on a mid to long-term basis, government officials are at the phase of starting to think about the normalisation of monetary policies.  

So, over the mid to long term, we think that the Japanese yen is on an appreciation trend. 

 Small-cap companies are more biased to domestic demand-oriented businesses. This appreciation of the Japanese yen would lead to a reduction of import costs for such companies, which should have a positive impact on earnings.  

DM: Can you please summarise why you see Japanese small caps as attractive today? 

JO: Japanese small caps are less volatile in terms of global economic movements.  

More than 90% of listed stocks are small and mid-cap stocks, with a market capitalisation of JPY 45 billion. 

And there is a high degree of diversity: [there are] many sectors such as banks, securities, raw materials, oils and so on. This means that compared to, for example, US equity, Japanese small caps have a lower correlation with those asset classes.  

The third point is information asymmetry or low coverage by sell-side analysts. For example, on average, Japanese small caps are covered by only one or two people.  

DM: Thanks, Sean. Thank you, Junki.  

SP: Thank you, Daniel. It was our pleasure.