This week: ASX v Wall Street
FYTD: ASX v Wall Street
This week we discuss each of two major topics
- Japan: why are we have selected to invest more heavily in Japan than global benchmarks
- Productivity: why is this a problem for Australia and how does it impact investment returns?
1. Japan – an overweight position
Clients would be aware of our more direct investment in Japanese equities within the International Shares sub-portfolio. This investment, via an index EFT, augments the indirect investment into Japanese equities as part of the MSCI global index investments. After hearing stories of stagnation and worse about Japan, one may wonder why we have this added investment.
The principal reason is that Japan has changed, global inflation has returned, and the global economic order is undergoing critical political and organisational change. Japan is likely to benefit from each of these trends.
The benefits have already begun to accrue to investors in Japanese equities, including our clients. In fact, as we speak the Nikkei 225, a broad index of companies listed in Japan, has finally begun to approach the levels last seen in the bubble of 1989.
Figure 1: Nikkei 225 Equities Index – retracing historic highs
Not all the changes have resulted in increases in the Australian dollar value of the investment, as the value of the Yen has also fallen. Despite the falling currency the net result has provided the strongest returns of all international markets we are invested in.
At the core of the investments is the fact that the Japanese market was inexpensive and under-owned by global investors. In addition, as a high beta equity market, Japan was likely to benefit from the global economic and trade growth post Covid. We can see that unlike many global markets including the US, the relative price measured by any of PE (price to earnings), CAPE (cycle adjusted earnings) or Price to Book (relative price compared to asset values) are all at or near historical lows.
Figure 2: Japanese Equities – A source of good value
Source: Minack Advisors
But cheap isn’t the only story – others are more important and relevant to recent strong performance and outlook. Developments that support the Japanese thesis include:
- Global onshoring and “friend-shoring” as the world moves supply chains away from China. Examples now include the political alliances of the Quad (Australia, Japan, United States and India), and policy support of the US IRA (Inflation Reduction Act) which is supporting new critical mineral and energy supply chains.
- Corporate earnings in Japan have had much higher sensitivity to the global production cycle than earnings elsewhere, and should only increase as reliance on China dissipates
- The strategic bull case for Japanese equities is that corporate Japan has changed. According to Minack Advisors commentary on the corporate sector
“It’s transformed from the market-share-chasing/low margin/high capex model of the bubble years, to one with a focus on returns and capital efficiency. Yes, there is a great deal of variation at the company level, but the aggregate transformation is clear.”
Figure 3: Japanese Corporate Profitability and Investment
Source: Minack Advisors
- More contentiously, but there is a core belief of our investment thematic that Japan benefits more from persistent higher inflation. Its significant in situ capital base coupled with the lack of low productivity investment required in Japan to support population growth mean marginal new activity can add significantly to real wages and company profits.
In the short-term the structural changes within the Japanese economy; the re-emergence of post-Covid global growth; and a shift in trade alliances are all working in favour of the Japanese equities trade.
Weakening Australian productivity results have prompted several excellent pieces of analysis by market economists. We discuss some of their results and our approach.
Productivity in economic statistics is defined broadly in line with common word usage, with a wrinkle. Labour productivity will be equal to the number of “widgets” produced in the economy divided by hours employed. Capital productivity will be the number of widgets produced divided by the fixed capital employed.
The wrinkle in the scenario is Multi-Factor Productivity (MFP) is especially important in the long run. When economies are strong and innovation is high, there will be improvements in output which are best explained neither by more labour or more capital but the synthesis between the two – these productivity improvements are known as Multi-Factor Productivity (MFP).
Equity investors love MFP. With higher MFP a company will be able to drive higher profits without expending more labour or capital than they did the day before. For policy makers MFP should also be the aim because whilst a country like Australia can always grow by getting more capital from foreign investors and getting more labour from the rest of the world, if that produces no more efficient use of existing assets then the benefits will be illusory at best.
Before we achieve MFP growth, however we first usually need to see improvements in labour productivity.
But in 2023, labour productivity has disappeared and there could be negative implications for both the RBA and investors alike. Labour productivity has fallen to be slightly below the level prior to the pandemic and unit labour cost growth has strengthened. So, we are deriving less output per hours and the amount paid for those hours worked is increasing. In a stable economy this would be problematic for profitability and future investment, but that stability is not an appropriate description for an economy re-emerging from Covid nor for one with a record spike in immigration.
Figure 4: Australian Labour Productivity – trend is not our friend
Source: Macquarie Bank, ABS
The decline in productivity this year is clearly shown in the chart. It is driven by simple maths: hours worked rose 7.2% year-on-year; hours worked per employee rose 3.3% yoy and there was little overall growth in total output. Excluding the Covid-restart, this growth in hours worked per employee is the largest since the data commenced in 1980.
Higher unit labour cost (ULC) is the result. That is:
More hours + more wages + similar number of widgets = the labour cost of producing a widget is skyrocketing
Higher ULCs can prompt central banks, including the RBA, to consider raising interest rates further to shock the economy into a contraction. This slows the growth of wages and protect the profitability of business for the sake of future growth and investment!! But wait….
One more detour required
One of the best ways to increase the productivity of an economy is to stop doing the unproductive things and spend more resources on what is more profitable. We invested in tractors to remove agricultural workers to work in factories, we educate our population and co-opt other countries’ educated to enable a higher skilled workforce. In short, we switch activity between low productivity industries and higher ones.
If there is higher ULC but at the same time we sustain this “switching industry” productivity the long run negative effects of weak labour productivity are less important, and the need to raise interest rates is lower.
Macquarie Capital analysis suggests that this “between industries” productivity change has remained positive since 2019, despite small falls in recent quarters. See figure 5 below
Figure 5: Labour Productivity Change
Source: ABS, Macquarie Macro Strategy
All the falls in productivity are “within industry effects” since 2019. And when Macquarie Capital dug deeper, they noted much of the impact of “within industry” was driven by Mining. Productivity remains positive in Professional Services and flat in Retail Trade.
Figure 6: Productivity change by industry – Mining is letting the team down
Source: ABS, Macquarie Macro Strategy
This combination is critical – if the level of profits in parts of the economy are already exceedingly high (which they are), we would argue that there are a couple of additional factors that would allay any remaining concerns.
- It may well be that firms are taking advantage of a wave of incoming cheap student labour to help facilitate the return to normal post Covid activity
- Given we have near record terms of trade it is highly likely that mining companies are finding it advantageous to simply hire more workers, regardless of productivity given strong pricing for ore produced
Productivity growth is, in the long run, all that matters. However, weak labour productivity if encountered through the turbulence of covid should be put aside if between-industry productivity switching remains positive, and company profits, especially in industries remain very high.
Without excess constraint from higher interest rates manufacturing a recession, firms will be able to concentrate on costs and productivity after they recover from a bout of high inflation and the transitional impacts of Covid.
To overreact to labour productivity changes could create feedback loops through the economy which are both detrimental and unrequired.