Our investment experts share their outlooks for Japan and China equities.
When you strip economic growth back to its basic parts, it is essentially powered by population growth, particularly a growing labor force, and improving productivity. In applying this equation to Japan, the country’s challenging demographic trends are well documented—an aging and shrinking population represents perhaps the biggest risk to Japan’s long‑term growth outlook. Crucially, however, Japan is taking action to counteract this challenge. And the magic word is “productivity.”
Japan is not the only country facing the modern reality of challenging demographics. However, among the world’s advanced economies, it is the country where the problem is most pronounced and, thus, where the imperative to act is most urgent. Accordingly, Japan is leading the way in pioneering new and innovative solutions aimed at boosting productivity.
Efforts to boost productivity are being driven by both the public and private sectors in Japan. On the public side, a focus on broad structural reform is creating a more flexible and dynamic working environment, with increased workplace participation a key objective. Meanwhile, the private sector also understands the need to boost productivity in order to stay globally competitive. Companies are investing in new technology and systems with the aim of encouraging smarter, more efficient work practices.
One of the principal “arrows” of Abenomics has been the overhaul of Japan’s corporate environment, in order to improve efficiency and encourage greater investment inflows. Significant progress has already been made here, most notably in the form of improved standards of governance and a new framework of tighter regulatory control. At the same time, a range of government initiatives, from new laws and policies to investment in infrastructure to financial incentives for companies, have all been specifically aimed at encouraging a more inclusive, and dynamic, Japanese workforce.
The historically inflexible nature of Japan’s labor market goes some way toward explaining why Japanese productivity has slipped behind global peers over recent decades. Tradition and culture meant that jobs were generally considered to be for life, creating limited competition and few opportunities for advancement, and so little incentive to move. This kind of inflexibility has a negative impact on productivity, in three key ways.
However, the legal confines that once enabled, even encouraged, companies to provide lifetime employment have today been largely removed. While it will take time for the ingrained one‑company “salaryman” mentality to unwind, the benefits of free and open movement are already apparent, with evidence of shared best practices between companies as well as increased employee upskilling, as competition for jobs intensifies. Businesses are also employing more staff on temporary or contract bases, which makes for a more flexible and efficient pool of labor than was possible in the past.
Meanwhile, Prime Minister Shinzo Abe has emphasized Womenomics—dedicated to making it easier for women to rejoin the workforce—as a central component of his economic growth agenda. A large percentage of Japanese women leave the workforce after their first child, and many never return to full‑time employment. In response to this problem, the government has announced several initiatives, including:
These policies are having success in encouraging more women back into the Japanese workforce. The percentage of working‑age women in employment reached a record‑high 72% in September 2019. This compares with a 67% female employment rate in the US, with the gap widening noticeably over the past five years.
However, there is still more to do. Japan’s gender pay gap, for example, remains one of the widest in the world, and closing this will be crucial for encouraging more women to stay in, or return to, the workforce. Also, the sharp increase in female employment over the past 10 years has been driven by a rise in the number of women working in part‑time or non‑regular jobs. This is encouraged by a tax framework that penalizes higher‑income‑earning households. Policy reform in this area, therefore, could see more women return to full‑time employment.
Encouraging older workers to remain in the workforce for longer is another government priority to help boost productivity. In 2013, a rise in the mandatory retirement age started to be phased in, from 60, rising to 65 by 2025. The government has also introduced subsidies for companies that employ or retain staff beyond retirement age. Meanwhile, companies are also realizing that valuable skills and experience can be retained for longer.
Crucially, after decades of underinvestment, the private sector is also beginning to act, with more Japanese companies investing in human and physical capital and pioneering new and innovative productivity‑enhancing solutions. Born of necessity, these companies are pushing the boundaries of what is possible today and, in the process, setting new standards.Japanese companies, for example, are investing heavily in automation and artificial intelligence technologies with the aim of improving or optimizing processes. In turn, this could potentially alleviate many of Japan’s social challenges, such as resolving labor shortages, releasing people from overwork, and improving productivity across a range of industries. While we are still in the relatively early stages of these disruptive trends, Japanese companies, both large and small, are increasingly utilizing intelligent machines and automation technologies. As this trend continues and broadens across industries, the impact on Japanese productivity could be significant. The most significant impact could potentially be felt in Japan’s service sector, where productivity lags that of the U.S. by some margin.
One of the hottest developing areas in technology currently is in service‑industry software, like robotic process automation (RPA). This is technology that can speak, hear, read, conduct transactions, and automate process‑oriented work. While it is increasingly being
used in all industries, more process‑driven businesses, such as banks, insurers, utilities, and telecom companies, are the biggest adopters so far. The software is helping these companies to automate procedural and repetitive tasks that would otherwise be done by human workers. If you consider that these industries currently employ thousands of people to do this kind of process‑driven work, it is not hard to see the efficiency‑creation potential offered by RPA software, enabling vast amounts of work to be automated. This is potentially transformational for Japan in terms of the productivity‑enhancing outcomes.
RPA Technology Is Potentially Game‑Changing for Productivity
One company that believes in the disruptive, productivity‑boosting potential of RPA technology is SoftBank. In late 2018, the Japanese multinational conglomerate invested USD 300 million in US startup business Automation Anywhere, which specializes in the field of automated technology. Investing via its Vision Fund, SoftBank is at the forefront of identifying and investing in disruptive technology businesses that it believes have the potential to lead the next age of innovation.
Abenomics has laid the crucial groundwork, delivering necessary structural reform, creating jobs, and encouraging investment. However, if Japan is to counteract its long‑term demographic challenges, then improving productivity is the key. To this end, efforts to boost workforce participation are bearing fruit, and this is an ongoing positive trend. Meanwhile, closing the productivity gap between the manufacturing and service sectors in Japan is also a priority. We can already see a positive dynamic starting to develop here, with the private sector investing in new technologies and systems, which is driving a “smart” upturn in service‑sector productivity. Importantly, the combination of public and private sector efforts could deliver a meaningful boost to Japanese productivity, counteracting demographic challenges and paving the way for potentially sustainable long‑term growth.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended by T. Rowe Price, and no assumptions should be made that the securities identified and discussed were or will be profitable.
There was a broad-based slowdown in the Chinese economy in 2019 arising from weaker exports, fixed investment, and property. Real gross domestic product (GDP) growth fell from 6.4% year‑on‑year in the first quarter to 6.2% in the second quarter and 6.0% in the third quarter, the lowest since 1992.1 Economic forecasters expect growth will fall below 6.0% next year, the minimum if Beijing’s long‑held target of doubling China’s GDP over 2010 to 2020 is to be met.
Beijing has not been panicked by a slowing economy into introducing another massive stimulus package as in 2008 or 2015. We think this signals a more mature policy approach, where official targets can be missed if circumstances dictate that is prudent. The Chinese economy’s deceleration since 2011 is partly structural in nature and is expected to continue.
Structural factors affecting growth include property peaking as a growth driver, a falling labor supply and aging population, the switch from manufacturing to lower‑productivity services, and a share of world trade that is no longer increasing. We believe that despite this less favorable background, China can continue to transition its economy successfully, balancing growth stabilization with deleveraging efforts while managing the impact of trade tensions, which seem likely to persist beyond the US presidential election next November.
As investors in Chinese equities, we look for leaders in industries that are undergoing consolidation, as well as gaining market share. For the longer term, we view China as a potentially rich source of high‑quality companies, with leaders that are successfully moving up the value chain, pushing out the boundaries of innovation.
Western financial media comment often focuses on the problems of China’s state-owned enterprises (SOEs). We think this is misleading since China’s SOEs and heavy industry are unrepresentative of the modern economy. It is the private sector today that drives the business cycle in China, accounting for 85% of urban employment2, 70% of total investment spending, and 60% of GDP.2
Tariffs not the main factor in china’s slowdown While President Donald Trump’s import tariffs have hurt China, we do not believe they were the major factor behind the slowing economy in 2019. First, the loss of momentum in China’s total exports in 2018/2019 mirrors closely that of other emerging markets (and also developed economies). This points to the weak global economy, not U.S. import tariffs, as a bigger factor in explaining China’s economic slowdown. The global trade slowdown will also have contributed to the weak performance of export‑oriented manufacturing investment.
Second, China’s financial deleveraging policies have remained in place for longer than was expected at the start of the year. “Shadow banking” flows, for example, as proxied by the sum of trust loans, entrusted loans, and bankers acceptances, fell 8% year‑on‑year in October.3 This partial credit crunch gave rise to strong financial pressures that fell mostly on China’s private enterprise sector, such as property developers and manufacturing exporters.
Another significant drag on the Chinese economy in 2019 was the cyclical downturn in the automobile sector, a shock big enough to reduce annual GDP growth by 0.5% on some estimates. Demand for autos in China was down 5.9% year‑on‑year in October,4 with sales at their lowest level since 2015. We expect demand for autos to begin to stabilize soon, in which case the headwind to growth from autos should fade and later reverse in 2020.
While China’s government has accepted lower trend growth, we expect a pause in deleveraging in 2020 and a switch to infrastructure spending from tax cuts in a more determined effort to support growth. In 2019, Beijing probably wished to keep some powder in reserve until there was greater clarity on trade. We assume a “phase one” trade deal is agreed with the U.S. and that China will introduce further policy stimulus that may succeed in stabilizing the economy close to 6.0%.
We have not seen significant monetary easing from the People’s Bank of China, China’s central bank, in 2019. China’s credit cycle troughed early in 2018, and there has been no strong acceleration since. There is good reason for this. Looser monetary policy could undo Beijing’s efforts to stabilize the residential property market over the past two years, igniting an asset bubble.
We expect further modest cuts in short‑term interest rates and in the required reserve ratio in the coming months. Monetary policy overall, however, is expected to play a subordinate role to fiscal policy in 2020. More fiscal stimulus measures are expected to be announced after the government’s annual economic work program meetings in December. The decision to allow local and regional governments to bring forward some of next year’s “special bond” quota (mainly used to finance infrastructure) is another sign that policy has switched from deleveraging to supporting economic growth.
The correlation of the A‑share market to real GDP growth is weak. Far more important for equities are nominal income aggregates, such as household incomes and wealth. These represent a more important growth metric for many domestic Chinese companies. The middle class in China continues to expand, with household income growing around 10% annually. Already, around 47 million wealthy middle class Chinese are in households with an annual income that is above USD 50,000 (RMB 351,500),5 a number that is projected to increase over four times in the next 20 years or so.
Many of the China stocks that we favor are supported by domestic demand rather than by exports. Hence, the actual direct economic impact of the US-China trade uncertainty on them may be quite limited, although sentiment can be more volatile. Investors should note that about 90% of listed enterprise profits in China are domestic. Only 10% are earned overseas, and the US share is a mere 3% to 4%.6 The uptrend in household income makes the story of the Chinese consumer one of the world’s most exciting for equity investors, and it still potentially has decades to run.
More and more Chinese households are buying products that are prominent in the western world, such as cars, electronics, cosmetics, and health insurance. They are also spending increasing amounts on food, vacations, and entertainment. “Premiumization,” or switching to higher‑quality brands, is also a big theme, as Chinese consumers are discerning and are increasingly demanding higher‑quality products.
China’s aging population will eventually act as a drag on demand. But in the interim, demographics may actually boost consumer demand, postponing the day of reckoning for the one‑child policy. Here’s how: About 44% of adult consumers in urban China fall into the 40 to 64 years age bracket.6 Many are “empty nesters” (i.e., couples, often with two incomes, whose only child has recently left home). China’s empty nesters tend to have more discretionary income available, while many will have paid down their mortgages. Consumer surveys point to them shifting their spending to “experiential consumption” rather than more of the goods that they have already acquired.
This has important implications for the growth in demand for specific products and services, particularly services such as tourism and entertainment. These empty nesters want to stay fit and healthy, spend more on higher‑quality food and beverage, travel more, and spend on home improvements. This is a rich vein for foreign investors to potentially exploit.
China A‑Shares: A growing opportunity Foreign participation in China’s onshore A‑share market is still only at a low‑single‑digit level (around 3%),7 even after inclusion in the key MSCI indices. Over the longer term, we are confident that international investors and fund managers will not wish to fall so far behind China’s new and rising benchmark weightings and will reposition their China mandates accordingly.
China’s domestic A‑share market currently accounts for nearly 70% of the investible China equity universe.8 It provides a growing and exciting long‑term investment opportunity for foreign investors. There are many new opportunities to be explored and potentially exploited, such as the small‑ and mid‑cap space, which, in China, tends to be very liquid, if at times volatile. Foreign ownership of 3% looks anomalous and out of line with other Asian markets such as Taiwan and South Korea, which are around 40% foreign owned.9 We believe that increasing foreign investor participation over time will not only help to underpin A‑share returns, it will also support greater transparency, working with the grain of the efforts of China’s financial regulators to improve the quality of domestic markets.
We also believe that an active, bottom‑up investment style is the best way to approach the expanding investment opportunity set in China. China’s domestic equity markets today remain inefficient, dominated by retail investors given the narrow local institutional investor base and marginal presence of foreign investors. This offers good opportunities for bottom‑up stock pickers to add alpha by choosing the right stocks. An edge in fundamental research should help foreign investors to identify good opportunities among China’s higher‑quality domestic equities.
Valuations in China have fallen significantly since 2015/2016. Even after this year’s rebound (Shanghai Composite Index +18.5% in USD, as of November 22, 2019). China A‑shares are still at very attractive levels. The market is trading below its post‑2005 historical mean in terms of trailing and forward P/E ratio, something that applies to few other major stock markets today. The 12‑month forward P/E ratio is 11.1X for MSCI China and 11.3X for the CSI 300 Index of top A‑share stocks. Consensus forecasts are for earnings per share growth of 12% and 9% for MSCI China in 2019 and 2020, respectively, and 17% and 14% for the CSI 300 Index.10
1 Source: Societe Generale: Country Briefing—China, November 26, 2019. 2 Source: HSBC Global Research, July 2019. 3 Source: CLSA Infofax, November 12, 2019. 4 Goldman Sachs: China Weekly Kickstart, November 22, 2019. 5 Source: HSBC Global Research, July 2019. 6 Source: HSBC Global Research, September 2018. 7 Source: Goldman Sachs Research, May 2019. 8 Source: Goldman Sachs China Research, May 2019. 9 Source: Goldman Sachs China Research, June 2019. 10 Source: Goldman Sachs Research, November 22, 2019.
Past performance is not a reliable indicator of future performance.
We will be watching for signs of stabilization in China’s domestic economy in the first half of 2020, especially with regard to private consumption and infrastructure investment. We will also monitor producer price index momentum closely for an end to deflation and a rebound in enterprise profits.