Hennessy Funds Commentary: The Impact of Coronavirus on Japan's Economy and Market
Masa Takeda and Tad Fujimura of Tokyo-based SPARX Asset Management Co., Ltd., subadvisor to the Hennessy Japan and Japan Small Cap Funds, summarize the economic impact of COVID-19 as well as the government's response. They also discuss the economic impact of a 2021 Olympics and SPARX's informational advantage.
How has Japan been affected by COVID-19 and how successful has the country been in controlling the spread of the virus?
Thus far, the number of confirmed infections as well as mortality rates in Japan remain fairly low relative to other developed countries on a population-adjusted basis. With a population of approximately 1/3 that of the U.S., Japan has recorded fewer than 17,000 infections and 900 deaths through May. A state of emergency was declared belatedly on April 7th, and the Japanese government did not implement stringent lockdowns across its cities. The state of emergency has now been lifted and restrictions have been loosened.
We believe the spread of coronavirus will be less severe thanks to the Japanese population being more comfortable with wearing masks. Also, social distance is embedded in the Japanese culture, where the norm is to bow rather than shake hands or exchange kisses.
Would you please summarize the economic impact of COVID-19 to date on Japan?
As in other parts of the world, a severe contraction in economic activity is already taking place in Japan. Although corporate earnings up to the end of March have not shown a significant negative impact, we expect to see them fall going forward. The March unemployment rate in Japan was 2.5%, only 0.1% higher than in February. This may not reflect the full impact to employment as Japan's COVID-19 infection cases only started to accelerate in late March and early April. However, and importantly, Japan's labor culture is such that "life-time employment" with low turnover is the norm, so layoffs are uncommon. As such, we believe Japan will experience a lower unemployment rate compared to other countries.
In the absence of lockdowns, people are still going about their normal daily lives, albeit to a reduced extent. Currently in Tokyo, foot traffic, public transit, and retail stores are down approximately 60%. We are seeing the curve flattening in Japan, but it's still too early to assess the full economic impact.
What stimulus has the Japanese government enacted to counteract the impact of the coronavirus outbreak in Japan?
Japan's policymakers swiftly enacted an economic stimulus package of approximately $1 trillion, which equates to over 20% of Japan's GDP and is double the scale of the stimulus package launched amid the 2008 financial crisis. Japan's stimulus is also the largest as a percent of GDP of any nation, significantly larger than the stimulus package enacted to date in the U.S. The Japanese government is considering additional stimulus of over $1 trillion, which would bring the total to approximately 40% of GDP.
On the monetary policy side, the Bank of Japan (BOJ) has pledged to boost purchases of assets spanning government bonds, commercial paper, corporate bonds, and ETFs. For example, the BOJ said it would "aggressively" buy ETFs at an annual pace twice the level it had pledged to buy previously. The BOJ also recently removed the ceiling on its bond purchasing program to allow for greater flexibility.
While we previously argued that the BOJ's quantitative easing had largely done its part with around $5 trillion worth of monetary base already in the financial system, and that the government should take the lead by pushing through structural reforms going forward, economic rescue plans should be prioritized above all else in times of extreme economic stress like we face today.
The combination of Japan's reform-minded, pro-growth government led by Prime Minister Abe and pro-business, pro-inflation central bank led by the BOJ Governor Kuroda provides a strong impetus to the economy recovery.
How has the quarantine in China affected demand for Japanese goods or supply chains of Japanese companies?
China's quarantine had a severe short-term impact, with most Japanese companies reporting their China operations had come to a screeching halt in February. But as China has largely succeeded in containing the virus, we have already seen signs of recovery, with business activities resuming.
For example, Fast Retailing (TSE:9983), the operator of UNIQLO clothing stores, was forced to close 395 stores or over half of their stores in China, which resulted in an 80% YoY decline in same store sales. However, in March, these stores had already resumed operations, and the pace of decline has shrunk to about 30% YoY and continues to improve by the day.
Currently, lack of demand is a bigger problem than shortage of supply. However, the COVID-19 pandemic has pushed the government to ask companies to reconsider supply chains that depend heavily on China. We believe that the supply chain will be diversified into other countries such as Southeast Asia, rather than returning to Japan.
Can you please discuss the economic impact of the Olympics being moved to 2021?
We believe the stock market had already priced in the impact of the postponement of the Olympics before the announcement was official. There are a number of changes to the original plans, such as sales of Olympic-related products, changes in corporate activities during the Olympics, the post-event development of the Olympics sites, etc. As long as it is postponement rather than cancellation, we can think that demand has been postponed to the next fiscal year accordingly. We believe that the market has fully factored in the forgone amount for this fiscal year.
What is your assessment of valuations of Japanese equities today?
Prior to the COVID-19 crisis, valuations in Japan were reasonable and compared favorably to other nations. Price-to-book ratios have fallen close to the lowest level in history. Assuming a full recovery of earnings over the 12-24 months, we believe current valuations are very attractive.
For perspective, from the beginning of 2013, the onset of Abenomics, to the end of 2019, the Japanese equity market (as measured by the TOPIX Index) and corporate earnings both grew by approximately 130%, indicating that the market appreciation was backed by steady improvement in profits. As such, our view was that Japan offered a fundamentally driven market where active managers could outperform the index.
Once the current crisis is over, we expect ultra-low interest rates, government-led structural reforms, and a continuous improvement in corporate governance will be tailwinds supporting Japanese equities. For these reasons, we believe that the recent sharp decline in the market provides an attractive entry point for investors seeking long-term exposure to Japan.
Have global "stay at home" orders impacted your ability to hold company meetings? How has being headquartered in Japan provided an informational advantage?
Our investment and research team continues to hold meetings in various forms, including telephone and web conferences. Robust data is readily available on large- and mega-cap companies, but restrictions have posed somewhat challenging for smaller-cap names because we focus on direct, on-site research. However, our cumulative research database and experience over the past 30 years sets us apart from peers.
Based in Tokyo, our competitive edge is our decades-long familiarity with Japan's business landscape and unique corporate culture, which allows us to analyze day-to-day research and translate insights into winning investment ideas. Such analytical advantage combined with a behavioral advantage of having longer-than-average investment horizons are what sets us apart from the competition.
What changes have you made to the Funds' portfolios over 1Q20?
Hennessy Japan Fund (Trades, Portfolio). We sold out of Japan Tobacco (TSE:2914) and Mitsubishi UFJ Financial Group (NYSE:MUFG) as we believe these companies will have relatively weak growth prospects even after the coronavirus is contained. The complete sale of Japan Tobacco is also a reflection of our commitment to an Environmental, Social, and Governance (ESG) investment framework.
On the other hand, we continued to increase our position in Sony (NYSE:SNE), a recently initiated position in 4Q2019, taking advantage of price weakness amid the market turmoil.
As a result, the concentration level of the portfolio has increased around our highest-conviction ideas, and the portfolio's active share currently stands at 86%.
Hennessy Japan Small Cap Fund (Trades, Portfolio). Stocks with good performance in the short-term, especially retailers such as food, daily necessities, logistics-related, and Internet-related have performed relatively well. However, valuations for these stocks are rather high currently, and there may be a negative effect in response to stockpiling. Therefore, we have lowered the weight of those stocks, especially retailers, and increased investments in stocks which are expected to recover earlier, such as electronic parts and semiconductors.
This article first appeared on GuruFocus.
