HIGHLIGHTS
- The fund underperformed its benchmark, the TOPIX Index Net, and its Lipper peer group average during the 12-month period ended October 31, 2022.
- The fund lagged its benchmark due to unfavorable stock selection and, to a lesser degree, sector allocation. Underperformance was due primarily to three factors: (1) the stronger performance of value stocks relative to their growth peers, (2) smaller companies coming under more pressure than their more internationally exposed large-cap counterparts, and (3) historic yen weakness. The fund’s returns suffered given its high levels of exposure to growth stocks, smaller companies, and firms that have tended to benefit from a stronger yen.
- The fund is most overweight the information technology and services and machinery sectors, while we have a less favorable view of commercial and wholesale trade and electric appliances and precision instruments. Over the review period, we closed our banks underweight, moving to broadly neutral. We continued to make adjustments at the margin to reduce the portfolio’s cyclical exposure due to concerns about slowing growth.
- Despite the uncertainty in the global economy at the moment, Japan’s corporates continue to buy back stock and return capital to shareholders at record levels. This is a very encouraging sign about the health of the corporates, as well as signaling the ongoing improvement in corporate governance at the company level in Japan.
Dear Shareholder
Nearly all major global stock and bond indexes fell sharply during your fund’s fiscal year, the 12-month period ended October 31, 2022, as investors contended with persistently high inflation, tightening financial conditions, and slowing economic and corporate earnings growth.
Double-digit losses were common in equity markets around the world, and bond investors also faced a historically tough environment amid a sharp rise in interest rates. Value shares declined but outperformed growth stocks by a considerable margin as equity investors turned risk averse and as rising rates put downward pressure on growth stock valuations. Emerging markets stocks generally underperformed shares in developed markets. Meanwhile, the U.S. dollar strengthened versus most currencies during the period, which weighed on returns for U.S. investors in international securities.
Energy was one of the few bright spots for investors, as oil prices jumped in response to Russia’s invasion of Ukraine and the ensuing commodity supply crunch, which helped some commodity-exporting nations in Latin America and the Middle East deliver positive equity returns. While results varied somewhat by region, typically defensive sectors, such as utilities, consumer staples, and health care, also held up relatively well. Conversely, diminishing consumer confidence put a damper on returns in the consumer discretionary sector, and information technology and communication services shares also suffered large reversals.
Inflation remained a leading concern for investors throughout the period. The war in Ukraine exacerbated already existing supply chain problems, and other factors, such as the impact of the fiscal and monetary stimulus enacted during the pandemic, exerted upward pressure on consumer demand and prices. While investors held out hope that inflation had peaked during the summer, inflation measures remained elevated. In the U.S., the core consumer price index, which excludes volatile food and energy costs, hit a 40-year high in September, while eurozone inflation reached a record level in October’s preliminary report.
In response to persistent inflation, global central banks began to tighten monetary policy. The Federal Reserve, which at the end of 2021 had forecast that it would only need to raise interest rates 0.75 percentage point in all of 2022, rapidly shifted in a hawkish direction and raised its short-term lending benchmark from near zero in March to a target range of 3.75% to 4.00% by early November and indicated that additional hikes are likely. The European Central Bank, meanwhile, raised its key interest rate to its highest level since 2009.
Bond yields increased considerably across the Treasury yield curve as the Fed tightened monetary policy, with the yield on the benchmark 10-year U.S. Treasury note climbing from 1.55% at the start of the period to 4.10% at the end of October. The sharp increase in yields led to historically weak results across the fixed income market, with the Bloomberg U.S. Aggregate Bond Index recording its worst month since 1980 in September. (Bond prices and yields move in opposite directions.)
On a positive note, the U.S. jobs market remained resilient during the period, and the initial reading on gross domestic product for the third quarter returned to positive territory after two slightly negative quarters. However, recession fears also grew as corporate earnings slowed and manufacturing gauges drifted toward contraction levels.
The past year has been an exceptionally trying time for investors as substantial sell-offs were the norm across both stocks and bonds, and we believe that volatility may continue in the near term as central banks tighten policy amid slowing economic growth. However, in our view, valuations have become more attractive across many market sectors during the downturn, which provides potential opportunities for selective investors focused on fundamentals.
We believe this environment makes skilled active management a critical tool for identifying risks and opportunities, and our investment teams will continue to use fundamental research to identify securities that can add value to your portfolio over the long term.
Thank you for your continued confidence in T. Rowe Price.
Sincerely,
Robert Sharps
CEO and President
FUND COMMENTARY
How did the fund perform in the past 12 months?
The Japan Fund returned -37.21% in the 12-month period ended October 31, 2022. As shown in the Performance Comparison table, the fund underperformed its benchmark, the TOPIX Index Net, and the Lipper Japanese Funds Average. (Returns for I and Z Class shares varied slightly, reflecting their different fee structures. Past performance cannot guarantee future results.)
What factors influenced the fund’s performance?
The fund lagged its benchmark due to unfavorable stock selection and, to a lesser degree, sector allocation. Underperformance was due primarily to three factors: (1) the stronger performance of value stocks relative to their growth peers, (2) smaller companies coming under more pressure than their more internationally exposed large-cap counterparts, and (3) historic yen weakness. The fund’s returns suffered given its high levels of exposure to growth stocks, smaller companies, and firms that have tended to benefit from a stronger yen.
On a sector basis, our choice of securities in information technology (IT) and services dragged the most, followed by stock picks in automobiles and transportation equipment and raw materials and chemicals. Conversely, our overweight position in retail trade, our below-benchmark allocation to electric appliances and precision instruments, and security selection in construction and materials added.
Within IT and services, Freee (TSE:4478, Financial) was the biggest laggard. The company, which provides cloud-based accounting and payroll software services, released its latest results showing that it had made a sizable operating loss, which is likely to widen in fiscal year 2022 as the company plans to increase spending on marketing and research and development. This should allow it to acquire new customers, however. Sansan, which focuses on the provision of business card management services to corporates, also weighed on relative performance.
Its new customer acquisition decreased significantly during the coronavirus pandemic, which meant fewer opportunities to exchange business cards. The firm stands to benefit from economic reopening. (Please refer to the portfolio of investments for a complete list of holdings and the amount each represents in the portfolio.)
In the automobiles and transportation equipment sector, truck manufacturer Hino Motors (TSE:7205, Financial), which remains mired in a fuel economy and emissions scandal, detracted. Carmaker Suzuki Motor (TSE:7269, Financial) was another laggard. The firm’s ability to raise prices has been constrained by its focus on the price-sensitive small car market. There are signs, however, that earnings at its India subsidiary, Maruti Suzuki, are recovering.
Within retail trade, shares of Pan Pacific International (TSE:7532, Financial) rose as the further easing of Japan’s border controls and an expected recovery in domestic traffic are expected to improve the outlook for the discount retailer. It also reported positive first-quarter earnings results in August. Leading drugstore chain MatsukiyoCocokara (TSE:3088, Financial) rose amid optimism about the continued easing of border controls as well as a recovery in domestic traffic. The company also reported positive first-quarter earnings results in August. Fast Retailing (TSE:9983, Financial), which operates the UNIQLO chain of basic/functional apparel, delivered a set of results that were well above consensus expectations and raised guidance more than was expected. In 2022, revenue growth in Southeast Asia, the U.S., and Europe has been strong, while China has lagged due to its coronavirus lockdowns, and Japan has been weak. We anticipate revenue growth in China to recover next year alongside an acceleration in store expansion elsewhere.
The top contributor to relative performance was Nippon Telegraph & Telephone (NTT) (TSE:9432, Financial). NTT is a high-quality telecommunications company with a solid balance sheet. Against a backdrop of uncertainty, investors preferred the defensive qualities and earnings of NTT because of its dominant market share in both fixed line and mobile.
How is the fund positioned?
The fund is most overweight the IT and services and machinery sectors, while we have a less favorable view of commercial and wholesale trade and electric appliances and precision instruments. Over the review period, we closed our banks underweight, moving to broadly neutral. We continued to make adjustments at the margin to reduce the portfolio’s cyclical exposure due to concerns about slowing growth.
Among banks, we added a holding in Mitsubishi UFJ Financial (TSE:8306, Financial), which we believe can offer relatively stable earnings and relatively good shareholder returns. We also established a position in Resona (TSE:8308, Financial), a leading commercial banking group in terms of market capitalization, capital, and deposit and loan base. It has high exposure to the retail and small and medium-sized enterprise segments.
Within IT and services, we decided to close our position in Recruit Holdings (TSE:6098, Financial), a leading human resources services company and major global player in temporary staffing. The business has exposure to the U.S. market through Indeed, and our conviction has lessened somewhat on concerns surrounding the risks to the U.S. jobs market.
We added electronics and media conglomerate Sony (TSE:6758, Financial) at an attractive valuation. We anticipate that the stock will rerate as a result of profit growth and user engagement from its PlayStation 5 product cycle from December 2022, as well as increasing demand for larger camera sensors.
Within transportation and logistics, we initiated a position in East Japan Railway (TSE:9020), which operates conventional and bullet train services as well as retail businesses in the Tokyo and northern Japan areas. We believe profits can recover from post-COVID normalization and increasing domestic and international travel.
What is portfolio management’s outlook?
Japanese equities are in the middle of the road at this stage. The country is among the most open and cyclical markets, and if the global economy, particularly the U.S., has a hard landing or tips into recession, then that will be a headwind for Japanese equities. However, the TOPIX Index is on little over 12x forward earnings when it trades on average around 14x forward earnings. Therefore, much of that bad news and negative sentiment is already reflected in valuations.
The yen has also fallen precipitously in 2022, due to the significant divergence of Japan’s inflation trends and central bank policy from other developed nations. This is important for two reasons: (1) the market is very attractive for foreign investors looking for cheap assets, and (2) the weak currency is supportive for Japan’s exporters, which represent a large part of the TOPIX and have become around 20% more competitive in 2022. These exporters are mainly the large-cap value names, while the sluggish currency has further compounded pressure on small-cap and growth investors.
The Japanese currency is at its lowest level in around 24 years versus the U.S. dollar—we believe that we are likely to see the yen strengthening from here at some point, particularly if inflation in the U.S. starts to roll over while remaining tepid and in line with the central bank’s target in Japan. We also note that the currency can move sharply; in 1998, the yen rallied by about 22% in less than three months, with about a third of the gains in over just two trading days. The currency can rally sharply from its current lows, and that would be supportive for the relative performance of small-cap and growth investors who have been under pressure. Small-caps are at their biggest discount relative to large-caps since the global financial crisis—that is excessive, in our view.
The views expressed reflect the opinions of T. Rowe Price as of the date of this report and are subject to change based on changes in market, economic, or other conditions. These views are not intended to be a forecast of future events and are no guarantee of future results.
