While still relatively unloved and under-owned, Japan’s economy is looking to pick up in the coming years and catch up on the global earnings recovery. Investor capital has continued to pour into the Japanese hedge fund industry over the past few months as foreign investors show increasing interest for Japanese equities. The potential for earnings per share growth is looking greater than ever, according to BNY Mellon’s Japanese equity investment team.

Giving a broad overview of the Japanese economy, Miyuki Kashima, Head of Japanese Equity Investments at BNY Mellon Asset Management Japan, explained that she has “never felt this positive for the long term” during her near 30-year career running Japanese equities. She argued that even given last year’s equity rally, which saw Tokyo’s TOPIX index gain more than 50 percent in local currency terms, the market was a long way off its peak. “The market hasn’t caught up to the earnings recovery since the financial crisis,” Kashima said, adding that she expects a 10 percent growth in earnings in the coming financial year.

As such, BNY Mellon, like many other international firms, has recently launched two new funds investing in Japanese small- and all-cap equities. This comes at a time when global funds have put more than $150bn into Japanese investments – despite still being massively underweight on the asset class. However, as 2013 data from EFPR Nomura reveals, investors have been underweight since 2008, but in the past year sentiment has grown gradually positive and pushed inflows into record territory.

Bullish on Japanese equities
The positive sentiments on Japan are also shared by other industry players such as Swiss & Global Asset Management, which is part of Switzerland-listed GAM Holding AG. The firm said in a recent outlook on Japanese equities that it expects double-digit annual profit growth for the asset class in 2014 and 15.

“Sustained currency weakness will continue to benefit most Japanese companies; a weaker yen will allow businesses to achieve an even higher level of profitability and will boost investment spending and wages. This will herald an end to deflation and boost the country’s economic growth,” the firm said in the paper.

Similarly, other global players have started investing in Japan and buying prime office locations in Tokyo and Yokohama. One example is Singapore-based investment manager Lotus Peak Capital, which recently launched a new fund of hedge funds product aimed at capitalising on Prime Minister Shinzō Abe’s economic growth strategy. The product will invest in 10 Japan-focused managers across different strategies, with a preference for equity markets.

“We did a fund of funds in order to have access to different sources of alpha. If you believe in the Japan recovery, you could buy an index tracker and wait – and that is fine, but probably fairly volatile – you are going to miss out on what we think is the really interesting story, which is the Third Arrow. Entire sectors of the economy need to be restructured, and that is where the alpha is,” said Managing Partner Stephane Pizzo, referring to the last leg of Japan’s current financial policy.

Abenomics to the fore
This faith in the rebound of the Japanese economy comes down to two particular points, Kashima explained. First, and most importantly, the country is experiencing a rare period of political stability, as the Prime Minister’s so-called ‘Abenomics’ looks to end deflation quickly by setting a target of two percent inflation to support a target of two percent real GDP growth.

Second, and as a result of this policy, public opinion on the Japanese economy is shifting, as Japanese investors, who had previously lost all faith in their own products, are slowly returning to the domestic market. As such, Japanese funds enjoyed $150bn in inflows during 2013, primarily boosted by foreign investors, yet with another $200bn needed for Japanese allocations to reach a neutral standpoint, there’s room for growth fuelled by domestic investors, explained Kashima.

Japan is coming out of a vicious deflationary cycle, and the national loan-deposit ratio remains at 60 percent – its lowest point in over 30 years, according to the Bank of Japan. With ample room to encourage lending, the potential for significant recovery is substantial, yet local companies have only just started borrowing again, as Abenomics begins to have a positive effect.

So far, the policy has helped fuel the yen’s depreciation against the dollar by more than 20 percent over the last year; increased availability of low-cost debt from Japan’s domestic banks; an attractive real estate yield spread over treasuries; and low rents and land prices across major Japanese cities.

As a result, Japan is back in the spotlight for international real estate investors. Recent surveys indicate that Japan was the third most active market globally in 2013 after the US and the UK, with transaction volumes of approximately $40bn, the highest since the financial crisis and an almost 70 percent increase from 2012. In addition, Tokyo is currently viewed as the top city in the Asia-Pacific region for real estate investment.

This has prompted a noticeable increase in activity from foreign institutional investors, including private and sovereign funds from the US, Europe, the Middle East and Asia (see Fig. 1) and, as a consequence, the burgeoning Japanese recovery is largely fuelled by global, long-term investors.

Cracking Japan
In this respect, 2014 could be a very good year for foreign investment managers looking to enter the Japanese market, as more local firms start awarding mandates to international players. As mentioned, this comes at a time when general interest in Japanese investments is picking up and the need for expertise on the market continues to grow.

In a joint study on asset management in Japan by Cerrulli Associates and the Nomura Research Institute, it was revealed that sub-advised funds accounted for 65 percent of investment trust assets under management as of 30 June 2013 – up from 61 percent in 2008.

Sub-advisory mandates, which take the form of either a discretionary mandate or a fund of funds brief, offer opportunities for foreign managers, especially in areas like foreign equity and foreign real estate investment trusts, where sub-advised funds account for over 90 percent of assets under management. To this end, the report indicated that the greater willingness of Japanese firms to do deals with foreign players should encourage Western private banks that have in the past found the Japanese market tough to crack.

“Foreign managers wanting to break into the Japanese market as a sub-advisor should target their sales activities at major investment trust companies as well as pension funds. It is crucial for foreign firms to ensure that these institutions are aware of where their expertise lies as they are on the lookout for distinctive asset managers from around the world,” said Sadayuki Horie, Senior Researcher at Nomura Research Institute.

Long-term gains
When asked whether Japan will contract along with Asian emerging markets such as China and India, Kashima insisted that money would not be pulling out of Japan, “because Japan never enjoyed money inflows post-crisis like China did. If anything, money should flow in,” she explained.

This claim is strengthened by a recent report from global hedge fund researcher HFR, which revealed that the HFRX Japan Index saw strong performance in the last quarter of 2013, as it gained six percent, ending 2013 up 32.8 percent. Asian capital inflows were led by allocations into Japanese-focused hedge funds standing at a total of $4.5bn in inflows for the asset class. This stands in stark contrast to Pan-Asian flows, which only reached $2.9bn, signalling that Japan is clearly outperforming the region.

In addition, Swiss and Global said that it expects profits in industrialised countries like Japan to approach pre-crisis levels. “We also expect comparable price gains in equity markets in the long term, with Japan rising in line with other developed markets,” the firm explained, adding that investors should focus on internet firms and market leaders, where there are payoffs to be found, even in the short term.

That said, though there is potential for the Japanese economy to truly pick up, it is not going to happen overnight, Kashima concluded: “This is a long-term recovery. At the current loan-to-deposit ratio of just 60 percent, Japanese banks have ample room to extend loans, but it will take time for companies to start borrowing again. So this so-called multiply effect that we’re expecting to see has five to 10 years’ potential.”