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From Japan With Love

Wealth managers often emphasize equities’ attractive returns in the long term. Planning for retirement with a large exposure to the stock market is presented as an infallible investment strategy. Except for anyone who invested in the Nikkei 250 in December 1989 when Japan was at the peak of global coolness. At face value, they would still be about 15% below their initial investment – more than 30 years later. This data point singlehandedly captures Japan’s infamous ‘Lost Decades.’

It is easy to be cynical about Japan’s willingness and ability to extract itself from its economic marasmus. Admittedly, there were many false starts, most recently ten years ago with Abenomics’ three arrows. But after a few days in Japan this week, I would note the evolution of four factors that may challenge the ‘Japan never changes’ refrain.

First, there are signs that the country is exiting a damaging deflationary period, with wage rises not seen in a generation. The war in Ukraine, a decoupling from China and its cheap labor, a declining workforce due to an aging population, and a dovish Bank of Japan have conspired to drive up inflation.

Second, the Japanese stock market outperformed MSCI’s global index by about ten percentage points in 2022 and is doing it again in 2023 (year-to-date). Evidence shows that stock market outperformance positively affects sentiment and corporate investments.

Third, there is a movement instigated by the government. In ‘Practical Guidelines for Business Transformation (2020), Japan’s Ministry of Economy, Trade & Industry (METI) states that ‘Japanese companies are urgently required to realign their business portfolio […] by smoothly divesting businesses’ to spur growth. Shareholder activists and private equity firms have quickly seized on the trends.

Fourth, Japan appears ready to play a more prominent role on the geopolitical stage. Such ambition would be commensurate with the country’s status as the only G7 country in Asia, its strategic location vis-à-vis China and Russia, its size as the third largest global economy, and its industrial prowess, which made it a global economic power. A new vision for Japan may inspire firms to invest in strategic areas such as tech, defence, or natural resources as a matter of long-term security and competitiveness.

Taken together, these factors could create dynamics allowing the country to break from the lost decades, follow METI’s non-sugar-coated advice about industrial reorganization, and get back on the economic growth path.

Over the last 30 years, Japan has seen annual M&A activity equivalent to about 1% of its GDP. This contrasts with more than 10% for the United States. Japan would need to engage in a vast industrial restructuring plan involving $15 trillion of M&A to catch up with the US’s activity over these decades. Even if the country were to implement a fraction of that activity, it would already be a big deal.

Firms expecting a transformation of Japan Inc. in the short term will be disappointed. Those able to spot the underlying trends and take a longer-term perspective, like Warren Buffett, could be handsomely rewarded.

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