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Investors Adjust to a New Era of Inflation in Japan

With Abenomics succeeding in pushing up consumer prices, investors focus on stocks in retail and real estate with pricing power.

  • By David Turner

A return to consumer price inflation in Japan was always regarded as key to the success of Abenomics, the plan by Japanese Prime Minister Shinzo Abe to revitalize the economy through fiscal and monetary stimulus as well as growth-oriented structural reforms.

Government officials hoped that higher overall prices would translate into corporate profits — and that companies would pump much of those profits back into the economy through higher pay. They also hoped that inflation would encourage consumers to spend that money. After all, one of the many pitfalls of deflation is that it encourages consumers to delay purchases in the hopes of getting a cheaper price.

To the great relief of the Abe administration, inflation has returned. Nationwide, core consumer prices were up 1.3 percent in the fiscal year ended March 31. “I do not think we will return to deflation as long as I’m alive,” says Genzo Kimura, 37, an economist at Tokyo-headquartered Sumitomo Mitsui Trust, which managed $474 billion as of December 31. Sumitomo’s strategy is to investigate and identify companies that have enough market power to be able to raise prices.

A rise in household earnings has sustained inflation’s momentum. A core tenet of Abenomics was weakening the yen, which has pushed up exporters’ profits and allowed many of them to increase wages in absolute terms for the first time in more than ten years. The continuing retirement of Japan’s baby boomers has also helped boost wages by creating a tighter labor market.

The increase in demand helped Japan over a crucial barrier in April: an increase in the consumption tax, to 8 percent from 5 percent. Many analysts predicted that the hike in this sales tax would depress consumer spending and end the nascent economic recovery, but early indications, including surveys of retailers, suggest that sales are already recovering after an initial fall. Analysts say the tax increase matters less when earnings are beginning to rise. Basic pay rose in January for the first time in 22 months, and this year’s round of summer bonuses — one of two bonuses typically given to employees in Japan — is expected to increase by about 1.4 percent.

Against this backdrop, companies have felt emboldened to preserve their margins by passing on the bulk of the tax increase to customers. Japan’s core consumer price inflation rate surged to 2.7 percent in April from 1 percent in March.

For investors who believe that the Bank of Japan will succeed in reaching its 2 percent inflation target, what are the best investment plays? Investors suggest companies that have the competitive strength to raise prices without losing customers.

“We want price makers rather than price takers,” says Sandra Crowl, member of the investment committee at Carmignac Gestion, a Paris-based €50 billion ($68.5 billion) asset management firm. Carmignac’s main global stock fund, Carmignac Investissement, has a 9 percent allocation to Japanese equities.

Japanese equities specialist Andrew Brown at Edinburgh investment management firm Baillie Gifford, which has £5 billion ($8.4 billion) invested in Japanese stocks, has a classic example of a price maker: Toyo Suisan Kaisha, which dominates Japan’s instant noodle market. “It sells very small ticket items and has a very high market share, so in theory, it should be able put prices up,” says Brown.

On the other hand, last year Baillie Gifford sold East Japan Railway Co. It was the perfect stock for the deflation era because its prices are fixed by regulation. But now, that same government regulation makes East Japan Railway’s stock unattractive. It needs government approval to raise prices, which is hard to obtain. Thus the company is likely to struggle in an inflationary environment.

Shigeo Mito, portfolio manager and Japan equities specialist at Sumitomo Mitsui Trust Bank in Tokyo, has his eyes firmly set on Japan. “It is better to focus more on domestic stocks, as the domestic economy is very strong,” he says. He notes that during the first stage of Abenomics, upscale retailers got a boost from the increase in consumer confidence. They were able to raise prices because their customers were not sensitive to prices. Now, he says, Japan is into the second stage, in which midmarket retailers can charge more. Mito favors two of them: shoe retailer ABC-Mart and apparel store United Arrows.

Carmignac likes the consumer discretionary sector. It increased its investment in online store Rakuten during the first quarter. However, it steers clear of stocks in sectors marked by low margins and a lack of clear product differentiation, including consumer electronics companies such as Sony Corp. “Highly commoditized products are the losers in environments of rising inflation,” says Mito.

John Vail, chief global strategist at Nikko Asset Management in Tokyo, advocates real estate stocks. He notes that the overall improved confidence in the economy has prompted real estate companies to put through plans for new, large office buildings. In addition, he says that anecdotal evidence in Tokyo suggests rents — a key constituent of Japan’s consumer price inflation index — are starting to rise.

The belief that pricing power is returning to real estate companies is echoed by Sumitomo’s Mito, who notes that in recent months vacancy rates have begun to fall from peak levels. Looking at what will boost the share prices, Mito says “the next catalyst is the rent of the buildings,” which he thinks will rise soon. Sumitomo recommends Mitsui Fudosan Co., which specializes in Tokyo office property, as a good play on rising rents.

A final option, espoused by Carmignac, is to invest in banks, which are exposed to the largely inflation-based recovery in the overall economy. Carmignac has holdings in Sumitomo Mitsui Banking Corp. and Orix Corp., the diversified financial services company.

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