Japan - A more dynamic market ahead
I started my career as a relative value trader in Japanese market in the late 1980s and early 1990s and with the benefit of hindsight I now realise what a golden age it was. Index futures were trading well above fair value, warrants and convertible bonds trading at zero implied volatility and there were heavily mispriced options markets. Relative value trading should never have been that easy. We all thought we were very clever at the time but in reality we were just at the right place at the right time. During this period, profits generated from trades in Japan helped to build many global hedge funds and bank proprietary desks; even for the global long short hedge funds the financial sector offered multiyear structural shorts.
As the 1990s and 2000s rolled past, Japan became less relevant as the mispriced opportunities dwindled and much of the talent pool drifted out of Japan into other markets. There were still periodic opportunities for a smaller group of niche traders. However, there were better opportunities in other areas of the globe attracting talent and other resources.
While relative value had declined as an opportunity set, new opportunities emerged.
The 2002 to 2005 quantitative easing (QE) driven equity markets were accompanied by a sustained period of small cap out performance. Japan long short funds grew rapidly and soon dominated the Asian hedge fund scene. We also saw the growth of activist investing. There seemed to be a real belief that Japan was about to exit the lost decade. However, there was negligible commitment to structural change at the top of the political structure and when Japan exited QE, the effects were disastrous. 2006 was a bloodbath for the strategy as small caps heavily underperformed and 2007 was not much easier as the BOJ sought to burst the perceived real estate bubble; all of this was followed by the global financial crisis of 2008. Despite all these events, the BOJ stayed relatively tight even after the return of deflation.
Japan also missed out on the post crisis recovery due to sustained Yen strength and growing competition from Asia. We then had the tragic tsunami and the Thai floods. Nothing seemed to be going right for Japan. They had also been forced to capitulate on industries that had previously been regarded as “too big to fail”, such as JAL and Elpida and the view of Japanese management quality and corporate governance was hurt by the Olympus affair.
The hedge fund industry had further problems with insider dealing scandals and a high profile fraud. By mid-2012, global consensus was that Japan was nothing more than a good source of shorts and even if you did trade Japan, it was not the country to set up base in.
During these years, most Japanese long short managers went out of business, especially those with a long bias or heavy weighting to small caps. The industry shrunk to less than 10 relevant larger managers of which over half were market neutral. The news was not all bad, as Japan still offered good stock selection alpha as long the beta was kept under control. Many of these survivors had generated an average alpha of around 5% p.a. for 5 years, even though 2011 to mid-2012 had been very challenging. The few surviving activists were able to generate alpha in excess of 10% p.a. for over three years. In simple terms, many businesses were trading cheap to their hard cash flow floors and one way or another the cash was getting returned to shareholders. However, there were also many other industries which were in secular decline with little recoverable value.
Outside equity long short, the credit markets offered some of the best opportunities. Credit research is underdeveloped in Japan with most investment grade credits trading too tight for the relative quality of their balance sheets, creating short credit opportunities using CDS. There were few buyers for sub-investment grade so it proved a great source of long opportunities. Basel III also created opportunities in bank sub debt. The relative value opportunities had gradually dwindled as the convertible bond market shrunk and the remaining deals moved far out of the money. Macro trading was challenging and attempts to short JGBs on growing Japanese government debt became known as “the widow maker” trade. The Yen proved stubbornly resilient. Many “tail hedge” funds wasted a lot of premium betting on the demise of Japan.
Many now say that Japan reached the edge of a precipice, looked over and did not like what it saw, so it voted for real change with the election of Shinzo Abe. What Abenomics has delivered so far is the monetary leg. We have seen a change of BOJ Governor and unprecedented levels of QE announced. There now seems to be clear determination to engineer negative real interest rates. The goal is to end the over saving of the corporate and household sectors and, in the process, reduce the growing government debt. Part in anticipation and part as a reaction, the Japan equity markets have returned over 65% off their mid-2012 lows and the Yen weaken over 25%.
The more challenging part for the government is going to be structural reform. If they win the Upper House elections this summer as expected, they will have a strong mandate. The issues to address are numerous and in many cases they are making the right noises in areas such as:
Free trade pacts
Some of the issues they can’t change quickly. The demographics are of concern and Japan is unlikely to accept major immigration changes, though they may expand their guest worker rules. They have a lost generation between 25 and 45 that have never enjoyed proper training and permanent employment - it is hard to reintegrate them into society.
However, based on the action taken to date there are certain assumptions we can make even if some of the structural reforms disappoint. The currency move will have a significant effect on corporate earnings. Irrespective of market direction, volatility is likely to be high for several years. The property sector has stabilised. Negative real interest rates will affect the allocation of domestic assets. Therefore, even if structural issues do not go away, we are likely to have a more dynamic market for a few years.
We suspect the easy macro directional trade may have already happened and it has helped to boost returns for the global macro managers in H2, 2012 and Q1, 2013; this was mostly played out in currency and equity. Some may argue the JGB sell off has yet to play out, but with these levels of QE any potential JGB sell off could be deferred for some time. There will continue to be a stream of news flow and policy initiatives, so the market will probably remain active for tactical trading.
An equity culture
Many are optimistic that Japan will be a strong alpha market for stock pickers and this should support strong long short returns. The 2012 rally proved too highly correlated, so while managers did capture some beta, alpha was quite poor. As the rally has matured in the first four months of 2013, alpha has been very strong. April looks to be the highest monthly alpha we have ever observed in Japan. The sell side has been cut back so heavily and there are a limited number of strong fundamental investors. Many of the flows have been macro or retail driven. Companies also have very different levels of operating leverage. In this environment good analysis should be well rewarded. Perhaps the biggest challenge we face is the limited number of managers and the lack of a pipeline of new managers.
After over two decades of bear markets, Japan has lost an equity culture. This creates a market place of many tactical traders and few long term investors. Foreign investors remain the more fundamental buyers of the Japanese market.
The convertible bond market has come back to life with more new issuance, as well as many of the old deals suddenly getting close to their strike prices once more. The volatility may remain structurally high for a number of years, so, the market could still offers a lot of value. That said. A lot more new issuance is required for it to return to its significant weighting in global funds. For the few niche managers that have a significant weighting to Japanese convertibles, the outlook could be promising.
Many Japanese companies are cash-rich which could result in a more active market in corporate events. Historically, Japanese mergers were all pre-agreed and traded at a minimal spread with little break risk, however, bumps in terms are becoming more commonplace. With a large number of listed subsidiaries in Japan, an opportunity may exist to take them private and in the last few years we note these appear to be being done at reasonable premiums. Corporate buy backs of equity continue to be on the increase as the deleveraging cycle has gone too far; corporate events may therefore provide significant trading opportunities.
Given the rally, many short credit trades have been unwound. Many businesses may still need to restructure but they now have a short term reprieve from improved terms of trade. This trade will probably come back at some point. Japan may continue to remain an attractive market for special situations when credit falls outside the investment grade universe.
In summary, the monetary action by Abe’s government has created enough change in the dynamics of the Japanese market that the opportunity set will remain attractive for a number of years. However, we have been though seven years of hollowing out of the Japanese hedge fund industry. This creates an environment where at the biggest challenge in exploiting the opportunity may be the limited number of experienced managers.