After eight consecutive quarters of expansion, Japan reported a slight decline in economic growth in the first quarter of 2018 but a solid recovery in the second quarter. What has been driving economic growth in Japan and what is your outlook for the rest of the year?
We believe two main factors were behind the slight deceleration in economic activity in 1Q18 in Japan. First, housing construction activity declined by 1.8% as banks pulled back from financing multi-family construction projects after seeing some softness in the rental housing market. Secondly, domestic consumption was weaker than expected, especially given the tight labor market and recent strength in wages.
While housing construction activity continued to show some weakness in the second quarter, consumption growth showed a strong rebound, and business investment spending rose at the fastest rate since 2016, fueled by information technology spending aimed at increasing productivity. We believe economic growth in Japan will continue to be powered by investment spending, as corporations focus on productivity and expanding output. We also expect more robust growth in domestic consumption in upcoming quarters and that GDP growth will be solidly positive for the full year.
Why should U.S. investors own small-cap Japanese equities today?
We believe small-cap Japanese companies look attractive as corporate earnings appear to have a lot of room to grow. One important driver of this earnings growth is the return to a more normal inflationary environment. After years of deflation, companies operating in the domestic market are finally starting to be able to raise prices, resulting in improved profit margins. We believe this greater pricing power is a long-term trend, likely to spread to more industries.
The second driver of the potential increase in earnings is the changing business and economic landscape in Japan. Deregulation, better transparency, higher standards of corporate governance, and a new emphasis on return on investment, are all creating growth opportunities in Japan. We believe smaller companies are able to adapt well to these changes.
We believe our rigorous research process can uncover opportunities among Japanese small-cap stocks overlooked by other investors. The Hennessy Japan Small Cap Fund seeks growth-oriented companies trading at reasonable valuations, which have the potential to provide investors with above-average returns.
How are Japanese companies benefitting from the fast-growing factory automation and robotics markets?
Small component producers and machinery companies are some of the primary beneficiaries of the growth in the factory automation and robotics industries. Factory automation systems need hundreds of components and smaller machines, and Japanese manufacturers supply these markets with some of the highest quality and technologically advanced products in the world.
As an example, one company we own in the Fund, Shibuya Corp., renowned for its automated bottling systems, has been successfully developing automated systems for other industries and is now supplying automated technology for growing cells for the biotech industry.
What impact might the recently imposed trade tariffs have on the companies in the Hennessy Japan Small Cap Fund?
A trade conflict could affect machinery companies fairly significantly, given that their orders tend to correlate with business sentiment. Fortunately, the Fund’s exposure to machinery companies is much lower than it has been, and is now in line with the benchmark. The auto industry could also be affected by tariffs. However, the auto component manufacturers we own in the Fund could potentially remain largely unaffected since they principally supply the Chinese auto market and have very low exposure to the U.S. auto market. More positively, if Japan agrees to further expand agricultural imports from the U.S., this could benefit some of our domestic stocks through lower input costs.
In summary, we continue to focus on the long term and, with or without a trade war, we believe Asian countries, including China, will grow faster than the U.S. and that Japan will be a beneficiary of this growth.