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Weekly Market Analysis - Japan – A Pause to Refresh
Posted on3 Things to Know
Positive Outlook for Japan
Japanese equities have range traded for three months after a 21% surge in the first quarter (measured in yen). Investors are wondering whether the Japan bull market has ended. To the contrary, such consolidations are common and healthy, while the fundamental drivers of our positive outlook for Japanese equities have not changed.
The BoJ is Set to Tighten Policy
Though recent intervention had been ineffective, the Bank of Japan (BOJ) is poised to gradually tighten monetary policy. Short yen positions are at extreme levels, leaving us to suspect a sharp yen rebound sooner or later. However, to achieve a sustained recovery in the yen, it will take lower US interest rates and repatriation of foreign investments by Japanese.
Bullish Trend May Resume
Japanese equities have not followed the yen's movements in the past 15 months. Rather, they have followed the stages of corporate reform. The next stage of reforms is likely now underway with the Tokyo Stock Exchange announcing further measures to boost its main index. Meanwhile, investor inflows are likely still forthcoming as Japanese households potentially increase allocations. While the market consolidated over the past three months, Japanese earnings continue to be revised up, reducing valuations. We suspect a resumption of the bullish trend is at hand.
Summary
Global investors may be stunned to learn that the top three US companies by market cap are now approaching the combined value of all publicly-traded companies in Asia or all of Europe combined (see chart). No, we are not referring to Asia ex-Japan or Europe ex-UK. We mean the "lock, stock and barrel" of each region. Two long-term US tech winners in software and hardware and one semiconductor upstart are together worth just US$200 billion shy of the US$10 trillion mark.
With our concentration risk vigil on, we are focused on opportunities away from today's market leaders. This brings us to markets such as Japan, a Citi Wealth overweight that has performed solidly in the past year, but has come under scrutiny as a market that has "rallied too much" in the view of some.
Portfolio considerations
Japanese equities represent a potential opportunity to capture Asian growth, with a critical part of the global semiconductor/tech supply chain being highly investible. Strong corporate reforms are creating fuel for earnings growth. Domestic and foreign investors are likely to add to allocations with reasonable valuations of 16x forward earnings.
Japan also represents an opportunity to diversify overly concentrated portfolios, whether in US mega-cap tech or Chinese equity holdings. We believe currency risk and related volatility remains. However, this can turn in the investor's favor once monetary policy normalization gets underway in both the US and Japan.
Source: Bloomberg as of June 26, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Positive Outlook for Japan
The MSCI Japan index reached a peak on March 22 of this year and has been in a 7% trading range since then. But on July 1st, the index made a new high, potentially signally a new breakout. Meanwhile, index earnings per share estimates have been revised up by 7% since March. This pattern of market consolidation and upward EPS revision was also visible in the second half of 2023, which was followed by a period of breakout performance. This took the forward PE ratio down to 16x, which is higher than the 10-year average of 14.6x. But given potentially higher return on equity (ROE), we believe that the valuations should also rise above historical average.
Among the MSCI Japan sectors, Energy, Financials, Industrials and Telecom had seen the largest upward earnings per share (EPS) revisions during the consolidation period. IT, Consumer Discretionary, Materials and Telecom have seen the greatest gap between stock performance and earnings revisions. These are likely areas that may see a catch up in the next potential stage of a reform-driven rally.
The BoJ is Set to Tighten Policy
The last time the yen exceeded 161 per USD was just a year after the 1985 Plaza Accord when developed nations coordinated to sell USD and buy yen. This time, Japan's Finance Minister Suzuki once again declared his heightened concern about the impact of rapid and one-sided currency moves and the need to watch FX developments with a high sense of urgency, sparking expectations for FX intervention.
BOJ Governor Ueda does not yet believe Japan is on a path towards sustainable demand-led inflation and cites the lack of pass-throughs of higher labor costs to service prices as the reason for the delay in raising rates. However, Japan's longer term inflation expectations continue to rise and the longer the BOJ delays raising rates, the more tightening it may have to do later. Caught in between these constraints, rates markets currently expect the next 10bp hike in September, and 62bps of rate hikes over the next two years.
Bullish Trend May Resume
The rally in Japanese equities over the past 15 months took place in two main stages, each a result of progress in corporate governance reforms, rather than yen movements. The first stage started in March 2023 when the initial Tokyo Stock Exchange (TSE) reforms targeted companies with a price/book ratio of below 1. This led to a wave of dividend and buyback announcements. The second stage started in at the beginning of 2024 on the wave of corporates announcing plans to unwind cross shareholdings, and to invest the dormant capital freed up from the transactions. These rallies took place partly because the corporate reforms moved forward to a next stage.
Foreign investor inflows have slowed in June but are likely to resume as more investors aim to capture corporate reforms and to take advantage of the cheap yen. In the first half of 2024, $40bn of inflows came to Japanese equities, far more than the $24bn in the entire 2023. Still, more could still come, as cumulative inflows remain well below the level seen during the peak of Abenomics in 2015.
It seems ironic that so many investors (albeit many from Asia), are concerned that Japan's equity markets could be peaking when US equities continue to power on to new all-time highs at a significantly higher valuation. Long gone are the days when Japan traded at 80X peak earnings and accounted for 45% of world equity market cap in 1989. Today, Japan shares represent a potential diversification opportunity with growth potential and value for suitable global investor portfolios.
We believe Japan is putting its long deflationary policies in the rear-view mirror. We see building and lasting momentum for corporate reforms to reward shareholders. Many of its firms are crucial to global supply chains. Volatility in Japan's currency may unsettle global investors in the year ahead. However, we see this culminating in the direction of a rebounding yen.
