Japan may be in recession, but someone forgot to tell Japanese companies.
Japan Inc. is busy cranking out profits. Earnings on the broad Topix index rose 20% from a year earlier in the September quarter for companies that have reported so far. For the two-quarter period when Japan was technically in recession, Topix earnings were up 5% from a year earlier.
The ever-weakening yen is flattering exporters’ profits, but that’s not the whole story. Analysis by CLSA strategist Nicholas Smith shows domestically-oriented sectors also posted gains in the third quarter, including a 6% rise for road and rail companies, and a 21% rise for electric utilities.
A return to inflation, albeit still mild, is giving companies renewed pricing power. Crude oil prices are down more than 20% this year, even after accounting for the effect of the weaker yen, providing a break on input costs.
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What’s more, a government drive to improve corporate governance and profitability is bearing fruit. Operating profit margins for Topix companies rose to 7% in the third quarter from 5.3% two years earlier, while return on equity improved to 8.4% from 4.0%. This measure in particular has been a focus, as companies with poor ROE are excluded from a new benchmark stock index.
The government hopes corporate prosperity will lead to a “virtuous cycle” whereby companies boost wages and investment. In fact, this was under way before April’s increase in the consumption tax short-circuited the process.
Including one-off summer bonuses, workers earned 2.4% more than a year earlier in July, according to government data, the fastest increase since 1997, which is a clear sign of progress. Wage growth has slipped since, but these figures are likely understated, as new workers—especially women in part time jobs—drag down the average. An alternative measure of total employee income was up 3.1% in July and 1.4% in September.
That wasn’t enough to overcome headline inflation of around 3%, but the blame for that rests on the tax increase, without which headline inflation would have been much lower. Pay is more than keeping pace with underlying inflation of around 1%.
There’s clearly something amiss in an economy that can’t withstand a small rise in the consumption tax without a recession and crisis of confidence. A consumer culture scarred by two decades of on-and-off deflation is likely to blame. Real incomes will need to rise on a sustained basis for consumers to see through small bumps in the economic cycle—and for companies to change their mind-set about investing. Pushing back the next consumption-tax hike until April 2017 creates a window for this to happen.
Meanwhile, there are reasons to stay optimistic on corporate profits. The Bank of Japan’s reupped stimulus plan has sent the yen falling sharply again. And there’s room for improvement in terms of profitability, with return on equity far below U.S. levels of 15.3% at S&P 500 companies.
Reforms, especially giving companies greater flexibility to dismiss idle workers, are probably needed to achieve U.S. levels of efficiency. But investors don’t need to wait around for that. Even after the recent rally, Japanese equities look inexpensive, at 13.9 times estimated 2015 earnings compared with 15.9 times for the S&P 500. That discount is a reversal from the historic norm for the two indexes.
Investors can still profit alongside Japan Inc.