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Recent economic reports suggest that Japan’s growth story is floundering. According to data released last month, the country’s rate of inflation declined in June compared to that in May. What was more worrisome was that the country has posted trade deficits every month for two successive years now. Wage growth is on the decline. Consequently, Japan reduced its growth target for the year from 1.1% to 1% last month.

Inflation Declines

Excluding fresh food, consumer prices increased 3.3% on a year-over-year basis in June. This is lower than the 3.4% increase reported in May and underlines the difficulties the Bank of Japan (BOJ) faces as it attempts to meet its inflation target of 2%.

In April, Japan raised its consumption tax from 5% to 8%, the first such increase in 17 years. The Bank of Japan estimates that this hike contributed 2 percentage points to May’s core inflation. But BOJ governor Haruhiko Kuroda acknowledged that inflation would decline over the next few months, wearing out the impact of the consumption tax hike. However, he remained hopeful that the central bank would be able to meet its inflation target for the year.

Income Growth Lags Inflation

While the pace of inflation declines, a recovery in consumption also remains elusive. This is because growth in income is failing to keep up with inflation. Average overall monthly earnings increased 0.4% in June on a yearly basis, compared to a 0.6% increase in May.

The decline in wage growth is also reflected in retail sales numbers for June. Retail sales declined 0.6% year over year and fell 7% in the second quarter. This is probably an outcome of the sales tax hike. Analysts believe that retail sales may fall below year-ago levels in the July-September quarter.

Exports Shrink

These problems had left investors hoping that exports would lift up growth. But exports contracted by 2% in June, while imports increased by 8.4%. The increase in imports was primarily attributable to an increase in fossil fuel purchases, following the closure of Japan’s nuclear plants. Exports also declined 1.7% by volume and were 23% lower in value terms than the high achieved in March 2008. This is in contrast to a 25% growth in U.S. exports over the same period.    

BOJ’s Deputy Governor Hiroshi Nakaso commented that the dip in exports was a result of low foreign demand. However, there is a general consensus among economists and market watchers that the decline is a result of Japanese companies producing goods outside the country to cater to foreign demand.

Domestic Production Fails to Increase

This indicates that a weaker yen, an outcome of sustained efforts by the central bank, has failed to boost domestic production. Policy makers believed that a favorable exchange rate would encourage Japanese companies to boost domestic production, leveraging the price advantage.

Instead, domestic companies seem to have cashed in on higher margins without actually increasing domestic production. This is particularly true for the likes of Honda Motor Co., Ltd. (HMC - Analyst Report) that have diversified production abroad to insulate themselves from domestic challenges.

Last week, Takahide Kiuchi, one of BOJ’s board members said: “Continued movement, mainly by Japanese automakers, to expand their overseas production through this year may be exerting downward pressure on exports with a time lag.” Kiuchi added, “The responsiveness of exports to overseas demand has declined significantly.”

Our Choices

Given the current environment, companies which have significant foreign production bases are good investment choices. Below we present three such stocks, each of which also has a good Zacks rank.

Toyota Motor Corp. (TM - Analyst Report) has three business divisions: automobiles, finance and another segment focusing on housing, information and communications. The company recorded earnings of ¥185.34 per share ($3.64 per ADR) in first-quarter fiscal 2015 (ending Jun 30, 2014), beating ¥177.32 per share ($3.58 per ADR) in first-quarter fiscal 2014 (ending Jun 30, 2013).

Earnings per ADR surpassed the Zacks Consensus Estimate of $3.07. The Japanese automaker posted consolidated net income of ¥587.8 billion ($5.76 billion) for first-quarter fiscal 2015, improving from ¥562.2 billion ($5.68 billion) in the year-ago quarter.

Toyota holds a Zacks Rank #2 (Buy) and has expected earnings growth of 6.4%. The forward price-to-earnings ratio (P/E) for the current financial year (F1) is 9.8.

Canon Inc. (CAJ - Snapshot Report) is an industry leader in professional and consumer imaging equipment and information systems. The company reported second quarter earnings of 72 cents per share, compared to the Zacks Consensus Estimate of 50 cents per share.

Earlier this year, Canon said it was shifting part of its production back home to capitalize on a weaker yen. However, most of the expansion in domestic production would be accompanied by a move towards factory automation.

At the same time, the company said it was not going to close any of its foreign production facilities. This means the move would not result in a substantial increase in employment while the company would continue with its foreign production units.

The company currently holds a Zacks Rank #2 (Buy) and has expected earnings growth of 7.3%. It has a P/E (F1) of 16.24.

Nidec Corp. (NJ - Snapshot Report) and its subsidiaries are primarily engaged in the design, development, manufacturing and marketing of small precision motors, mid-size motors as well as machinery and power supplies. Nidec also produces other products, which include auto parts, pivot assemblies and encoders.

The company’s manufacturing operations are located primarily in Asia and Nidec has sales subsidiaries in Asia, North America and Europe. It also has manufacturing locations in Thailand, China, Singapore, Indonesia and Vietnam.

Apart from a Zacks Rank #2 (Buy), Nidec has expected earnings growth of 48.9%. It has a P/E (F1) of 23.5.

Despite current headwinds, it is unlikely that the effect of Abenomics will fade completely. The BOJ is likely to provide additional monetary stimulus towards the end of this year. However, until Prime Minister Abe is successfully able to implement structural reforms, long term growth remains elusive. This is why these stocks would make good additions to your portfolio.

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