Update on Japan

Country Spotlight – January 2017

Key points

  • Investor sentiment on Japanese equities has rebounded on the back of recent yen weakness and continued attractive valuations.
  • Continued accommodative policies from the Bank of Japan as well as Fed rate hikes are likely to support a weaker yen in the near term, which may help sustain this rally.
  • While many risks remain, these factors and the turnaround in flows underscore why investors should consider an overweight to Japan.

Rebounding sentiment in Japan

After $12bn of net industry outflows from Japanese equity ETFs through the first three quarters of 2016, equity market sentiment has rebounded abruptly. Japanese equity ETFs had $2.5bn of Q4 inflow with the asset gathering momentum carrying over into the first week of 2017 (+$414m through January 13). The two flagship iShares Japanese equity ETFs, iShares MSCI Japan ETF (EWJ) and iShares MSCI Currency Hedged Japan ETF (HEWJ), account for 70% of the inflow since the end of the third quarter. Notably, Q4 inflows into HEWJ were the largest since mid-2015, suggesting a significant turnaround in currency hedging sentiment.

Investor sentiment has been buoyed by recent weakness in the yen, and market expectations for continued weakness support Japanese equities. Moreover, valuations are still very reasonable for Japan when compared with global benchmarks.

Yen weakness

The yen spent the majority of early 2016 as a safe haven, strengthening as the global picture became bleak, and remaining strong through multiple stimulus measures from the Bank of Japan (BoJ). However, BoJ policy shifts at the end of the summer to target yields and buy “unlimited” Japanese government bonds (JGBs) at fixed rates have begun to weaken the yen. Moreover, steepening yield curves in the US post-election have served to widen the difference in interest rates between the US and Japan, which has further catalyzed yen weakness.

Japanese equities and a weaker Yen

Japanese Equities and the Yen

Source: Bloomberg, as of 1/10/2017

Attractive valuations

Throughout the Abenomics period, Japanese stocks have traded at a discount to global markets. The discount reflects a range of challenges facing the Japanese government: persistent deflation, the need for structural reforms, as well as an impending labor force cliff approaching the aging nation. Equities rallied strongly in the years when monetary policy was effective, but have lost momentum recently. If fiscal and monetary policy globally are regaining efficacy, this could create a new uniform condition where monetary policy is once again beneficial for Japan.

 

Relative valuations

12-Month Forward Price-to-Earnings Ratios (Japan vs. ACWI)

12-Month Forward P/E Ratios (Japan vs. ACWI)

Source: Bloomberg, as of 1/10/2017

Attractive valuations
Price-to-Book Ratios (%)

Attractive valuations

Source: Bloomberg, as of 1/10/2017

Conclusion

Positive sentiment toward Japan is largely driven by expectations of yen weakness and monetary policy efficacy, but this bullish sentiment is not without risks. Global trade and potential rising protectionism could be a concern, and the limits of monetary policy mean Japan could have fewer tools to help if growth does not accelerate as expected. However, Japanese earnings estimates are rising to a near two-year high, and BoJ equity purchases, rising corporate share buybacks and dividend payouts are additional positives for growth. This momentum, combined with continued yen weakness, suggest it is time to take notice of the turn in sentiment and consider hedged Japanese equities.