Why 'cautious' Ruffer is going big on Japan

One of the more remarkable aspects of the Japanese equity market, and one that is little appreciated by private investors, is the dearth of domestic ownership.

Japan's economy may be the world's third largest, yet its stock market is driven in the manner of emerging markets (China aside) by footloose foreign money.

The Japanese government, whose actions frequently mystify, last year emerged as a top 10 shareholder in 90 per cent of companies on the all-important Nikkei 225 index, an achievement that does not appear on any regulatory filings because the trades were restricted to exchange traded funds.

As one prominent observer noted at the time, action of this sort distorts the sanity of the stock market.


Reasons for the absence of genuine domestic participation in Japan Inc can be traced back to the late 1980s, when the Nikkei 225 topped 39000. In the wilderness years, it fell in 2008 to as low as 7000.

A generation of investors were wiped out by that calamity, and that poisoned potential investors of the next. Japan is now a nation of cash hoarders, a reality that aggravates the country's twists and turns with chronic deflation.


To today's fans of Japan's investment merits - and few are more enthusiastic than David Ballance, a key manager at investment firm Ruffer - the value on offer in Japan's equity market is peerless.

Yet identifying this value is one thing; without wider and sustained support for this perception, the spoils could prove stunted.

Ballance, co-manager of Ruffer Investment Company and its open-ended stablemate, CF Ruffer Total Return, says many Japanese companies have only a scant following, if that, among analysts in the west.

Thus when a member of Ruffer's team made a visit to one of the forgotten, management were so thrilled that they marked this auspicious honour by raising the Union flag.


Ballance, whose investment brief is wealth preservation, a position that saw Ruffer sail through the 2008/09 crisis, adopts a multi-asset approach to investment.

As the contrasting forces of anxiety and optimism echo around a world fixated by president-elect Trump, he is increasingly wary of equities, and has been for some time.

He is driven by value, not geography, when picking stocks. He has a scattering of holdings in other global markets, but finds 'very compelling reasons' to be drawn, in the main, to Japan.

Fiscal expansion - the equivalent of $45 billion (£36.7 billion) of state-sponsored spending was announced last year - is one of these: another is that the 'third arrow' in prime minister Shinzo Abe's reformation quiver is starting to hit home.

This concerns deregulation and corporate governance reforms.

Japan's ambitious reforms: buying opportunity, or another false dawn?

These, in essence, mean companies should be run for the benefit of shareholders and not management.

Those that qualify are rewarded by being included in Japan's new stock index, the Nikkei 400. 'Japan is a consensual society and many companies want to be in it,' says Ballance.

Japanese companies have historically been cash hoarders, he says, but this is changing and dividend payouts are rising. Property prices are also creeping up: 'Banks are pretty robust and ready to lend.'

Partly because they were still mopping up after the 'lost decade' of the 1990s, Japanese banks did not get caught up in the lunacies that brought on the global financial crisis.

Banks and the financial sector represent his main Japanese equity exposure. 'Banks are selling at eight times earnings and 0.8 per cent of book value,' he says.

But for Ballance, Japanese equities are something of a side bet, albeit a significant one. They account for around half his one-third weighting in equities, but the main focus of his assets is index-linked gilts, primarily index-linked US Treasury bonds and UK issues.


Ballance has been patiently waiting for the inflationary flames to be relit and, suddenly, he feels his time is nigh.

He is waiting for president Trump to show his hand. 'One of the few things we know about him is that he's prepared to borrow and spend.'

And, he notes, post-election traders in the US equity market were quick to rub their hands at the prospect of billions of dollars of new spending on infrastructure projects.

Provided his expectations for higher inflation are met, Ballance predicts 'there will be some difficult episodes to navigate. Inflation is the enemy of financial assets and we worry there will be no place to hide'.

He says his funds started to buy UK index-linked securities in 2008, when they offered 'huge value'.

'Up until now we have made money on our index-linked holdings but we have reached a critical juncture. We will have rising inflation in the UK post-Brexit, and greater fiscal activism around the world creates inflation.'

The rise in US 10-year government bond yields from 1.8 to nearly 2.5 per cent shows people are already pricing in inflation, but, he says, 'I would want to buy them on a higher yield than this'.

Austerity hasn't had the desired effect. 'Quantitative easing bought the politicians time and saved the world from depression,' he explains, but the austerity game is over - if not in Germany.

One of the more difficult asset classes to assess right now, he feels, is emerging markets. Much will depend on whether president Trump follows up on the campaigning rhetoric of protectionism.

'Emerging markets are very trade-dependent and our exposure to Asia is very low.' Ballance asserts that it 'seems unrealistic to believe the US can just take jobs back from China to Ohio'.

'The supply chains are in place,' he says, and it would be a huge task to readily replicate them in the US. 'But we need to wait to see where US trade policy really is heading.'

Unlike some, Ballance is not yet fretting about China, burdened with its huge corporate and real estate debts, capital flight and a sick banking sector. 'We see China as a chronic problem. We don't expect it to blow up any time soon.'


Ballance has long included gold in his asset spread - through both gold shares and the physical asset. 'We can vary the mix.'

Many gold-mining companies, he says, are now better disciplined and adjusting their cost structures to a period of lower prices rather than the $1,800 per ounce level enjoyed in the last period of euphoria.

'We keep our exposure because we have this nagging feeling we need it as a protection against paper currencies and monetary instability in all its forms.'

Still, from here, he expects a period of dollar appreciation - subject to fiscal expansion proceeding as envisaged and the US administration not moving sharply to the right.

In much the same way as, say, a drug dealer might lend his buyers money to support their addiction, the US and China have a 'vendor financing' system in place, whereby China lends its vast surpluses to prop up the US economy.

Ballance indicates that some deft footwork might be needed to maintain this relationship, especially if China's access to US markets for its goods is given the cold shoulder and US interest rates do not please Beijing.

As for sterling, the equity markets, he points out, have had 'this sugar rush' from Brexit and a falling currency; he echoes others in believing the inflationary ghosts will appear in a new form.

'Inflation has always been the reliable way that allows governments to wash away their sins, and we don't see that it won't be the same this time.'

The odd man out in this incipient era of fiscal expansionism is Europe, a reality that could change overnight if Germany moves away from its rigid platform of austerity. 'But they don't have the desire to do that.'

Ballance adds: 'We don't have much of our money invested there, as we expect any new fiscal policies will take a while to root.'

The elements of a euro crisis are latent. He points to last year's resounding 'no' in the Italian referendum aimed at bringing more stability to government, and this year's French presidential elections followed by parliamentary elections in Germany itself.

'All of these have the ability to throw up difficult results. We've taken our equity risks elsewhere.'


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