Turning Japanese...

My New Year Attack of the Vapors

It is New Year and time for some new stock picks.

This year is not done, so I will report on my Crazy 8 China A-Shares in a day or so.

That was a classic contrarian bouquet of eight Chinese stocks at a time when the folks who know stuff, I mean financial journalists, were calling the collapse of China.

China did not collapse, and most of our stock picks turned out fine.

This year I am not calling stocks, but an entire country.

The top pick I have for 2025 is the country of Japan.

This will probably shock the same journalists who called the collapse of China last year.

Who cares? Why pay attention to folks who know diddly squat about global markets?

Let's explore Japan, and the reason why I am Turning Japanese.

No sex, no drugs, no wine, no women
No fun, no sin, no you, no wonder it's dark

Yep, with that popular rap, this is (yet) another contrarian bet.

Japan looks dull unless you know something about the place.

The Cult of American Supremacy

We are now living through an era which is a carbon copy of times I have seen before.

The contrarian investor in me gets excited whenever I witness a time when everyone has a widely shared belief which is patently false. When investors parrot ideas which are obviously wrong, you know there is an opportunity. You just have to find it.

In this case, it is the mythology that the USA is an innately superior nation.

Rest assured, I am not betting against the USA, but I am underweighting the country.

Why? Why choose to underweight one of the best performing markets? Why now?

It all comes down to the downside of dominance.

When you are the biggest game in town the view is mostly downwards.

This explains a great deal about the present geopolitical environment.

If you fear losing what you have, thinking naturally turns to prevent the rise of others.

This was the basis for my pick last year, when the Chinese market was in the gutter, and nobody wanted to buy it. The story is different now and more nuanced. I would continue to own selected China A-Shares. However, I think the headwinds from US Foreign Policy, will remain a heavy drag on the Chinese economy. 

There is a clear containment policy which is aimed at preventing China from rising in technologically advanced fields.

You can debate the merits of this approach, but the intent is clear.

I call this the Tonya Harding strategy. If your opponent looks too good, then bring out the trusty claw hammer and break their kneecaps. That will work!

You may view my analysis as churlish and uncharitable.

However, I saw this exact same movie before playing out with Japan in the 1980s.

Japan got too good at manufacturing, so the Plaza Accord claw hammer came out, Japan was forced to revalue the Yen upwards, and a few lost decades followed.

The contemporary USA has a short memory, and so all of that is forgotten now.

China is the bogeyman, not Japan!

However, it has not been forgotten in Japan, which is why you want to place some of your betting capital on a sustained Japanese renaissance. Japan knows it is "not us" who will have their kneecaps broken by the claw hammer of US Foreign Policy.

On this view, Japan is a relative winner from the "kneecap China" strategy.

Of course, there are other candidates. which are also strong in manufacturing, like South Korea, Taiwan, Germany and emerging giants like India and Vietnam.

These could win global share on advanced manufacturing products that might otherwise come from Chinese factories. With the exception of Germany, which kneecapped itself with energy policies which have destroyed manufacturing competitiveness, they all have merit.

However, the reason that I am focused on Japan has to do with advanced tooling.

Japan is the quiet achiever in many areas that underpin intelligent manufacturing.

The Era of Intelligent Manufacturing

To segue into our major investment theme of 2025, it helps to consider why Vietnam and India are strong contenders to win global manufacturing market share.

They are populus nations with low labor costs and a sufficient pool of well-educated engineers to manage and operate integrated manufacturing supply chains.

In relative terms, this means that Vietnam and India can copy the China playbook and target Western markets with cost-competitive volume manufacturing. This is more palatable to American interests than cheap labor in China.

Apparently, cheap labor in China hollowed out US manufacturing, but switching to Vietnam and India as new cheap labor, in a foreign supply chain, will bring it back!

Politics is Muzak played at high volume to discourage critical thinking.

The reason that American manufacturing hollowed out was the commercial decision by firms in America, run by Americans, with a good chunk of American shareholders, to make better margin selling US designed but foreign made products to Americans.

Having sanctions fly could certainly move some manufacturing away from China.

However, the commercial logic that caused Apple to source components and assembly of the finished product in China has not magically changed. 

If Americans became poor enough, the American assembly sweatshop might become a commercial reality. Booyah!

There are Made in America moments for the behemoth from Cupertino. However, beyond the feel-good press releases there is little substance in the onshoring drive.

Computer maker Dell Technologies is well-regarded for its supply chain smarts. Over a year ago, it was reported that Dell's US Product Line Rumored to Cut All Chinese Ties by 2027. Digging into that story, this did not mean US sourcing or manufacture. It was simply the exclusion of China sourced product. This will please politicians.

The idea that manufacturing of advanced consumer technology products will flood back to the USA ignores too many factors to list in this short article. 

It is simply a non-starter. Vietnam, yes. Kentucky, no.

Looking at global development trends, and the rise of Artificial Intelligence, alongside the development ambitions of many nations in the Gobal Majority (the G7 share of the global population is less than 10% and shrinking), such policies are unlikely to work.

The offshoring and AI-shoring rate of high-paying service industry jobs will likely exceed the onshoring of manufacturing industry jobs. 

Western factors of production are simply too expensive.

This does not mean there is no opportunity, but it must face the brutal commercial logic of land prices, labor prices, energy prices, and availability of talent. In this respect, countries like Australia have to be very selective of which industries we enter. 

Land prices were made very high in Japan, following their 80s real estate boom. Three decades of brutal deflation have cured Japan of that disease. Japan is now showing a mild increase in land values. The great deflation is on the mend.

Australia has low labor productivity growth, high land values, high labor costs, and, oddly enough, high energy prices in a land of abundant renewable resources, fossil fuels, and uranium. There is a hill to climb, and little appreciation that something needs to change if we are to climb it.

If any progress is to be made, on improving productivity, it will have to come from the pursuit of more productive service and manufacturing organization. In the case of manufacturing, it will require higher rates of capital Invesment in plant and tooling. 

The cheaper way to move forward would be to work with Chinese manufacturing interests in growth industries. In many Western countries, including Australia, that avenue is being shut through official policies that restrict the involvement of Chinese supply chains.

Although Japanese labor productivity has itself stalled in recent years, the nation retains a high manufacturing share and has global exposure in robotics and semiconductor equipment. The Japanese expertise in sophisticated supply-chain management follows the past successes in the automotive and consumer electronics industries. Finding the new bright spots is key.

Oddly enough, Japanese labor productivity improved the most when the economy was doing worst. That was a period of strong performance for export-oriented Japanese manufacturing. This is not crazy. Hard times led to increased capital expenditures on efficiency gains.

The brighter story in long-term productivity growth is the USA.

Hang on a minute?

Did you not start this Japan puff-piece with a dump on the "Cult of American Supremacy"?

Indeed, I did. Guilty as charged. Whatever the USA has been doing has been working well.

However, I also said that I was not betting against the USA, just moving underweight.

The key is valuation and understanding the role played by Japan in geopolitics.

Japan wins on valuation, but also the role their companies play as enablers of intelligent manufacturing, through machinery, components, and specialized materials.

Can trees grow to the sky?

In my view, the trick to positioning for the remainder of this decade is to understand who is best positioned to take advantage of US-Chinese rivalry, without itself becoming a rival.

In short, the favored strategy is to play both sides, which means having something to offer which both sides want, and ideally need, but which is not itself a threat to either.

Australia could play this hand very well but has not figured it out the game.

From what I can see, Japan has figured out the game and knows how to play it well.

To put this in context, have a look at the country weights in the S&P Global 100 index, as computed from the ASX listed ASX: IOO ETF. The USA is now about 70% of global market indexes, like the MSCI AC World, but it is even more of a large company index.

This is a success story, to be sure. The US markets have outperformed other markets.

 

When measured in AUD terms, the S&P Global 100 has outperformed the S&P ASX 200 by about 5.9% p.a. over the last ten years. Furthermore, it did so at lower risk when unhedged.

During that period, the S&P Global 100 was dominated by the rise of US stocks.

If you consider only US stocks, via the S&P 500 ASX: IVV ETF, the performance was slightly higher, and much better when the currency was left unhedged. 

This has been a strong ten-year period for both USD and US stocks.

There is no question this has been a terrific ten years for owning the US market, but it is now a concentrated market that is dominated by technology platforms.

This market tree is not yet scraping the sky, but it is looking extended.

The valuation question

Generally, I prefer picking stocks over entire countries.

However, the last section serves to illustrate that success in one area of the economy, the one dominated by a particular country, can easily upset the stock picking apple cart.

You may have started the last decade by picking stocks in technology. However, if you picked the then leaders, you came out ahead and had ultimately picked a country.

The same was true of Australia in the 1990s with banks, and the early 2000s with resources.

I am not suggesting that Japan will be the same story, as a country, but share a recent analysis by JP Morgan strategist Kerry Craig, that influenced my thinking.

It is not customary to sing the praises for a competitor, but when the ideas are sound, I am happy to borrow them. Exhibit "A" above is from an Evergreen Asset Allocation meeting I was lucky enough to attend, so a shout goes to them also.

I caution to add, Japan was not the primary subject of discussion. However, the above chart caught my eye. This shows the total return of each market, in AUD, and the source of return, across earnings growth, valuation multiple, dividends, and currency. 

Three aspects of this chart struck me:

1. Australia was not the worst market, but it was all multiple expansion and dividends
2. The USA was the best market with a good chunk from currency and multiple expansion
3. Japan has the best earnings growth with better returns than Australia

This is an interesting dynamic. I will go into greater depth in another piece that looks over the important changes in Japanese markets over the past few years.

However, the key historical story is told by the right-hand chart. This compares the current valuation versus the 20-year historical average and the range over that period.

India, the USA, the World and Australia are well above average and towards the top of the range in historical valuations. China is close to the bottom of the range.

Japan is in the middle, around the historical average, has a cheap currency, and some real momentum in market reforms that are attracting foreign investors.

This is the market condition I like. Not deep value, more like Goldilocks on the up.

Historically, the AUDJPY rate is towards the top of a 20-year range.

Note that the Japanese Yen has traditionally been a safe haven currency.

This is certainly the case when looking at the AUD-JPY cross rate. When US markets are weaker the AUD-USD cross rate tends to tumble, and the JPY firms.

The reason for all this to-and-fro is that I prefer to run global equity strategies on an unhedged basis, since there is natural hedging for global equites on an AUD basis.

In plain language, Australia has an economy which is highly sensitive to any retreat in global growth due to the large commodities exposure of our exports. The Australian currency tends to fall more sharply to the downside when global growth weakens.

I am already invested in US markets and want to reduce US exposure by buying other markets at the margin. I am also invested in Australian markets and looking to reduce exposure to a domestic market that looks expensive. 

Selling AUD now to buy Japan looks good.

However, I expect US market strength to continue in 2025.

If I trade Australia for Japan now, I can let the USA run and take profits to reallocate, as I see fit, in the second half of 2025. That is a good way to glide into an underweight.

This is why I am happy to buy Japan. Once the USA notices Japan in the rear-view mirror they will beat up on the Yen to revalue versus USD.

I expect AUDJPY to weaken from here, so the broad timing is right.

To buy the stocks now, on improving earnings, with JPY competitive looks good.

A strong currency juices stocks in the short run, through funds flow, but a weak currency juices trade, and thus stocks, in the long run.

This story gets more interesting at the individual stock level.

I will save that for later.

For now, I am turning Japanese.

Photo by David Edelstein on Unsplash