Due to the strength of the Yen, it is no surprise that overall corporate pre-tax profit margins in Japan decelerated in the recent quarter. But before one panics and says that they are about to plummet, one should realize that there are structural corporate-governance reasons for this long-term upward trend and that at least for services, the 2005-2007 period showed that profit margins can plateau at a high level for an extended period of time. Indeed, while the overall four-quarter average fell from its record level, this is due to the impacts of the soft global economy (including weak capital expenditure in China) and the strong Yen, while the non-manufacturing sector, which is nearly entirely domestically focused, remained at record highs.

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth
(for all non-financial companies, not just listed ones)

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth (for all non-financial companies, not just listed ones)

Sources: Japan Ministry of Finance, Bloomberg, data through CY2Q16.

...and for Non-manufacturers (excluding financials):

Four-quarter Average of Pretax Profit Margin vs. Japanese Nominal GDP YoY Growth for Non-manufacturers (excluding financials)

Sources: Japan Ministry of Finance, Bloomberg, data through CY2Q16.

The fact remains that, partially due to the encouragement of the Abe administration, Japanese corporations are continuing their structural shift towards higher profitability. Abenomics is "icing on the cake" of the "Show Me the Money" corporate governance improvement that we have long-highlighted in our thought leadership effort on Japan.

Indeed, while increasing the number of independent directors and other recent governance issues are very important in the intermediate term for Japan, it is crucial for investors to understand that much of the profitability message has actually been understood by Japanese corporates for over a decade. This is shown by the divergence in the profit margins from the trend in GDP growth in the charts above, showing that even though GDP growth has remained subdued, profit margins have surged.

Since the Koizumi era, Japan has embarked on major rationalizations in most industries, with the number of players often reduced from seven down to three. The fruits of this restructuring were slower to ripen than in Western world examples, and they were hidden by a series of crises (the Lehman shock, the turbulence in China, the strong Yen and of course, the Fukushima crisis), but since Abenomics began, the global backdrop for Japan has been stable and there have been no domestic crises, thus allowing the fruits to ripen.

Conclusion

We expect that the overall four-quarter average profit margin will decline mildly in coming quarters due to the stronger Yen, but that non-manufacturing margins should remain at a sturdy level. Both sectors should experience continued industry rationalizations and cost-cutting. Of course, if the Yen were to weaken, the overall profit margin would likely move back to, or above, its recent highs. One should also note that Ministry of Finance statistics do not cover post-tax income, and due to recent corporate tax cuts, the overall net profit margin (excluding extraordinary write-offs) is likely expanding even more sharply than the pre-tax data shown above.