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Written by: Darius McDermott
10/08/2017
Japan appears to be somewhat of an oddity right now. In spite of the negative headlines surrounding prime minister Shinzo Abe's leadership, demand for Japanese shares remain strong.

Abe’s popularity has fallen, following allegations of favours for two school operators with personal links to the prime minister. According to the pollsters, the approval rating for Abe’s government currently stands at 38% – far below 67% in January. His party, the Liberal Democratic Party (LDP), also suffered a historic defeat in the Tokyo elections in early July. These developments have caused some to question whether Abe has what it takes to win a third term in power in 2018.

Looking beyond the headlines, Japan remains popular with UK-based investors. The market attracted net inflows of £168m in June, according to the Investment Association, topping off a strong first half in which Japanese equity funds brought in £652m.

Why are investors willing to shrug off concerns about Abe’s leadership credentials? One of the main reasons is valuation. Japan was the only developed market that was trading below its historic average in valuation terms at the end of June, according to JP Morgan Asset Management. In a world where investors are struggling to find cheap stocks and markets, there is much to be said for this.

Scorecard for Abenomics

Abe’s sweeping reforms, dubbed ‘Abenomics’, aim to break Japan’s 20-year deflationary cycle. They comprise of three ‘arrows’: quantitative easing (money printing), fiscal stimulus and structural reforms.

The third arrow includes initiatives to improve corporate governance, raise salaries and get more people working. So far, the government’s efforts in this area appear to have gained some traction. This is demonstrated by labour shortages, which economists hope will stoke wage growth.

It is encouraging to see dividend growth and share buybacks at record highs. Meanwhile, the economy has continued to expand over the five consecutive quarters up to the end of March 2017.

Inflation remains subdued, however. Core consumer price inflation rose 0.4% year-on-year in June – unchanged from the previous month. This is something Japan has struggled with for decades and is only likely to come through in a meaningful way once a cultural and behavioural shift has been embedded.

Four and a half years since Abe came to power, has the easy money been made? Over this period, the Topix index has risen by 110% in sterling terms, while the average fund in the Investment Association’s Japan sector is up by 105.3%.

Right now, the Japanese stock market looks more attractive than other developed markets and is supported by positive earnings growth. The profits of exporters could also receive a boost from recent yen weakness, which highlights another key consideration for investors looking at the region – currency. If you do not wish to make a call on the yen, I would suggest investing via a ‘hedged’ sterling share class.

It is also worth remembering that Japan is a cyclical market, which means it is highly correlated to global GDP. The market swings between favouring growth and value fund managers, so it makes sense to hold a combination of funds with complementary styles.

T Rowe Price Japanese Equity features among our favoured funds in this space. It has been a strong performer since Abe came to power, with a 132% gain. Manager Archie Ciganer focuses on companies that are undergoing change and is happy to take a long-term view.

Baillie Gifford Japanese is a good option for those looking for a growth tilt. Managers Sarah Whitley and Matthew Brett target well-managed businesses with a strong competitive advantage. Since December 2012, they have achieved an impressive return of 153.6%.

Will Abenomics prove to be a success? I think the jury is still out on this one. Nevertheless, Abe has achieved a number of small victories during his time in power. As the opposition remains in disarray, something tells me his policies will live on for some time.

Darius McDermott is managing director of Chelsea Financial Services

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