The bullish case for investing in Japan has been widely publicized in recent years. Since late 2012 when Shinzo Abe became prime minister, the government has been trying to revive the Japanese economy from decades of deflation, stagnation and low interest rates. Abenomics has been implemented through monetary easing, fiscal stimulus and structural reforms. In addition, there have been changes to the corporate governance code and improvements to shareholder rights. As a result of these policies, Japan-focused hedge fund managers highlight the rising stock market in Japan. They will point out that companies are now utilizing cash on their balance sheets to create and unlock value for shareholders. And they will emphasize the increased opportunity set for activism and event-driven investing.
However, what most managers fail to mention is the decline in stock market liquidity in Japan. PivotalPath gained this insight from speaking with Japan-focused equity long/short managers in person last month. Liquidity is low because the central bank has been buying while the retail investor has been selling. The Bank of Japan for years has been purchasing Japanese stocks as part of its massive stimulus program; notably, the central bank now owns 80% of the domestic ETF market in Japan. This has recently been exacerbated by the lack of interest from retail and foreign investors in the region, who have exited Japan in search of more attractive regions such as China.
So what does all this mean? The indiscriminate buying by the BoJ has led to distorted valuations in Japanese equities. Managers state that stock prices are no longer being driven by fundamentals and, specifically, are not reacting to news or earnings as they should. For example, when companies have been releasing negative news or earnings, stock prices have not been negatively affected; instead, stock prices have remained artificially high due to the buying. This has been especially problematic for strategies that are more fundamental, have a meaningful short book, are more short-term oriented and trade around earnings announcements.
In order to compensate for the distortion, managers have had to adjust their strategies. Specifically, they have chosen to run with smaller short books, maintain lower levels of risk, and stay diversified in this type of environment. We speculate that managers have been increasing their net exposure, as the short side has been more difficult due to the BoJ buying and the lack of liquidity.
Despite the concerns, managers believe the issue is temporary rather than structural. What might reverse the liquidity crunch? The BoJ recently started to taper its purchases, which should lead to better price discovery for stocks. In addition, you could start to see renewed investor interest in Japan, which would bring back the retail investor. Participants at the conference reiterated the bullish case for Japan. They also emphasized the fact that the profitability of companies has been improving and the number of share buybacks has been increasing.
Nevertheless, there is the risk that Japan cannot escape the liquidity trap. In December 2019, prime minister Abe announced another round of fiscal stimulus to support economic growth. However, the measures ultimately may prove to be ineffective – in that case, the BoJ could be forced to resort back to its stock-buying program. The government also recently announced a new law that is considered “anti-activist” against foreign investors, which may lead to additional outflows from the region. Investors should be wary that the liquidity crunch could turn out to be a structural problem. Only time will tell if there is a gradual normalization of liquidity in the Japanese stock market.