Where the Risks Aren't
For investors worried about downside risk, Japan appears once again to have been the most immune to the usual business-cycle risk factors.
Investors are worried about coronavirus, rising unemployment, a wave of corporate defaults, and the still-lofty valuations for growth stocks in most developed markets.
But there is one country that looks to us relatively immune to these risks: Japan.
Coronavirus
Despite catching it sooner than most, to date, Japan has nearly completely escaped the coronavirus, with only 6.8 deaths per million compared to 300 to 580 per million for the US and parts of Europe.
Figure 1: COVID-19 Impact by Country
Source: Bloomberg
Unemployment
Japan’s unemployment rate ticked up from 2.5% in February to 2.6% in April, whereas in the United States nearly 15% of workers were suddenly unemployed in April. Japanese unemployment swings were similarly muted in the 2008 crisis.
Figure 2: US and Japanese Unemployment through the 2008 Crisis and Today
Source: FRED
After decades of demographics trending older, Japan entered this crisis with a historically insufficient labor supply, according to the nation’s survey of Japanese corporations. And the government’s actions on coronavirus job-retention programs (and relative inaction on complete lockdowns) seem to have contributed to the relatively low unemployment in Japan today.
Bankruptcy
Almost all corporate debt in Japan is investment grade. Aggregate corporate debt has declined significantly over the last 20 years in Japan, and about 60% of publicly listed Japanese firms have net cash balances now. Corporate lending rates are about 1%, and lending is still extremely accommodative according to the Bank of Japan’s latest surveys. The opposite is true in the United States, where aggregate corporate debt has risen, speculative-grade debt has taken up an increasing share of lending, and interest rates are significantly higher.
Figure 3: Total Corporate Debt / GDP
Source: FRED. Total corporate ex-financial debt in USD.
As shown in the figure below, the rise in US corporate debt has primarily been fueled by an increase in speculative-grade debt.
Figure 4: Credit Quality in the US over Time
Source: S&P
This millennium, Japan has had almost no corporate bankruptcy, with less than 1% of publicly listed firms filing for bankruptcy in the worst of the 2008 crisis.
Figure 5: Bankruptcies of Publicly Listed Japanese Corporations
Source: Teikoku Databank
As we see it, this dramatic difference in quantity, quality, and base rates makes Japan one of the least scary developed markets if you are worried about a default cycle.
Valuations
In our research, price collapse of extremely expensive stocks has been a greater statistical risk of permanent capital impairment than actual corporate default in firms with debt. Going into this crisis, Japanese stocks already had very low prices.
Growth stocks globally were extremely expensive going into this crisis. And at the median, stocks were about as expensive in the US and Europe as they were going into 2008. However, we’ve noticed that the Japanese stock market was the only major developed market where valuations did not rerate over the last decade as profits improved. This global divergence in valuations made Japan look historically quite cheap compared to the US and Europe going into 2020.
Figure 6: Global Valuations at the Median Stock through 31 March 2020 (TEV/EBITDA)
Source: Capital IQ. All listed public stocks >$25mm market cap excluding REITS and financials.
At Japan’s low valuations, low bankruptcy rate, and low unemployment rate, we have a hard time seeing why the same downside case for global equities would apply to Japan.
Of course, what happens outside of Japan matters tremendously for the trading nation, and markets have priced in a worse short-term reaction to the pandemic in the US and Europe in year-to-date returns. But for investors worried about downside risk, Japanese stocks appear to have been the most immune to the usual business-cycle risk factors, as they were in 2008.
There are many other things to be worried about in Japan (government debt, GDP growth, population trends, corporate capital allocation) which matter. But the last few months have reminded us how some financial systems are much more fragile than others in the face of events that aren’t and can’t be priced in. It’s nearly impossible to predict a pandemic, war, or election outcome ex-ante, but corporate credit quality and valuations are relatively measurable.
Despite these factors, there has been an exodus of fund flows from Japan over the last few years. And with that exodus, the subordinated equity in one of the least fragile corporate debt markets in the developed world got cheaper and less crowded in our opinion. For those worried about the length and severity of a corporate default cycle, Japan’s low equity valuations and high-quality corporate credit seem to imply a favorable ratio of reward relative to risk going forward.