Japan as a core equity position
After two decades of disappointing stock-market returns, Japan had become the pariah of the international investment community and only recently has it started to look like it is ready to rejoin the mainstream of core market allocations. To hardened sceptics, this is just another in a series of false dawns. But there is clearly a group of investors, including many viewed as very smart, who think Japan is finally making the changes needed to rejoin the mainstream.
In a recent Position Paper, Japan in a global equity model, we examine whether Japan has disqualified itself from being a core part of a UK investor’s equity exposure. We do so from two perspectives:
whether or not the past real returns delivered to both Japanese and foreign investors are fundamentally different from other equity markets and hence are or are not consistent with an adaptive capitalist system providing similar long-term rewards for taking equity risk;
whether Japan is, as some think, ‘ossified’ or is in fact adapting to the extreme stresses it has experienced.
Tight management of portfolios that require a high level of certainty about both ‘paths’ and ‘outcomes’ means being sure about the way the individual portfolio building blocks will behave, singly and when combined. Only assets with evidenced ‘systematic’ return behaviour can come close to providing this much certainty. At Fowler Drew, the ‘risky asset’ building blocks for these tightly-managed goals are large, developed, liquid equity markets. These show the characteristics of economic ‘systems’ and it is plausible if not provable that they are actually functioning as systems. This is what gives them a degree of predictability.
This view of the equity return process, equivalent to a ‘global equity model’, is widely accepted within the investment industry, here and abroad, either explicitly (as an expressed set of beliefs) or by implication (from the way portfolios are typically constructed). However, it is not entirely obvious that Japan’s equity market fits this description. Its long-period real equity return trend has been quite unstable and ‘mean reversion’ does not appear to occur in the way we expect of equity markets. Whereas business and politics appear to need to change and adapt in order for systematic return behaviour for equity markets to persist, Japan gives the appearance of being unable to adapt.
We believe that this doubt is unfounded. Japan does fit the model. It should also inform our views of what can happen in other developed markets.