Wednesday, July 2nd, 2014

Feast or Famine

In the last month our recommended weighting in Japanese equities has risen to 9%. However this rally will be very different from the previous one, driven by reform not devaluation. Then, there was a 25% fall in the yen dollar FX rate. This time the currency has been fluctuating within a narrow 5% band. The issue on which all hopes are pinned is a comprehensive reform of the tax system for companies. Detail is still in short supply, but according to Prime Minister Abe, the broad outline has been agreed. The reforms will be spread over several years, but the first wave will be implemented in the new fiscal year which begins in March 2015, and substantive details will be published in December this year – no doubt with numerous leaks beforehand.

The key issues are (1) expanding the tax base to include smaller firms, (2) reducing the headline rate and (3) reducing the scope for tax deferral (mainly through accelerated depreciation allowances). There is also some discussion of making the reforms tax neutral for each industry, which looks like a hopelessly complicated idea to us. Tax reform is never interesting, even in one’s own country, and it is very easy to get lost in the econometric modelling, so let us focus on the main market effect.

Most Japanese companies use the same depreciation rate in their financial accounts as they do in their tax computation. This means that they over-depreciate from an economic perspective, by comparison with international companies which use different assumptions for tax and financial accounts. Thus, if Japanese tax allowances and depreciation rates are reduced, published earnings will rise. At the very least this will make them more comparable with international companies. It may also persuade domestic investors that equities are more attractive than they thought.

So far the message has been upbeat, but this is Japan. It has missed numerous opportunities for structural reform in the last 20 years and the idea of raising the tax rates on small businesses is unlikely to be a vote winner. We are also cautious about buying into another rally which is led mainly by foreign, not domestic buying.

Our final reservation concerns sector rotation. Our Japanese model has Energy and Consumer Staples as its top two sectors, followed by Technology and Industrials. Going back though the last 20 years, we can only find one example where the market rose significantly while Energy was ranked in the top three sectors, and that was between February and September of 2005.

Most of the time, Energy fulfils its normal role in Japan, acting as a drag on corporate profit margins and consumer spending. A high ranking for Consumer Staples also suggests that investors are not betting on a strong cyclical recovery – at least not yet. By contrast, Consumer Discretionary is ranked #7.

However, as Japan has proved many times before, when investors want to buy equities, a good story is often more important than a good economy.

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