Our Company and Sites
October 2017

The case for Japanese equities

Despite potential political uncertainty surrounding the October 22 "snap" election, we currently favor Japanese equities.

Supportive factors include:

  • Improving earnings outlook amid a strengthening domestic economy and synchronized global expansion.
  • Currently attractive equity valuations compared to developed market peers.
  • Continued monetary stimulus from the Bank of Japan and a potentially stable yen

Weak investor positioning could be reversed with a market friendly outcome.

Japanese economic and equity market fundamentals are currently strong, but it's the political backdrop that’s caught investors' attention this year. Japan's Prime Minister Shinzo Abe surprised markets by calling a snap election to be held on October 22. Abe and the ruling Liberal Democratic Party (LDP) have seen their popularity steadily decline this year. However, with the opposition in disarray, and a slight bounce in recent public polls favoring the LDP, Abe called an election. Still, we continue to favor Japanese equities.

Economic fundamentals intact

Japan is experiencing its longest expansion in over 10 years, and strong growth over the past year has led consensus growth expectations for Japan to more than double over the past year.1 Japan's competitive export position leaves it well positioned to potentially benefit from global growth in our view. Strong economic momentum has translated into robust earnings growth and upward earnings revisions. Yen strength remains an equity risk, although growing policy divergence between the Bank of Japan (BoJ) and both the European Central Bank (ECB) and Federal Reserve could continue to put downward pressure on the yen.

Trailing Twelve Months Total Return

Trailing Twelve Months Total Return

Source: Thomson Reuters, Oct 10, 2017. Indexes shown are the MSCI Japan Index, MSCI Emerging Markets Index, MSCI EMU Index, MSCI Asia ex-Japan Index, MSCI All Country World Index, MSCI USA Index, MSCI United Kingdom Index. Multiple expansion refers to increases in the price-to-earnings ratio. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Equity market responding to
stronger fundamentals

Japan's equity market has responded to these positive economic developments, with the MSCI Japan Index up 26.2% over the last twelve months.2 Double-digit earnings growth and positive earnings revisions may continue to support the strong outlook, in our view. Despite higher expected earnings growth, strong earnings revisions, and outperforming over the last twelve months, Japan currently trades at a 21% discount to U.S. markets on a 12-month forward price-to-earnings basis, and trades at a discount to its own history.3

More shareholder-friendly corporate behavior may also support Japanese equities going forward. Improved corporate governance, investor appetite, and growing corporate earnings alongside record cash balances provide the necessary supply and demand ingredients that could help increase shareholder payouts going forward. Over the past five years, 3Q has been a the seasonal low point for buyback announcements before rebounding during Q4 and Q1.4

Investor positioning and flows don't match the fundamentals

Japanese ETF flows have been choppy this year, bucking two of this year’s top trends: (1) flows into international equities and (2) flows into unhedged ETFs after persistent USD weakness this year. The increase in international equity flows this year has been a dominant theme. Investor risk appetite for international equities seemed to increase further over the summer as investors rotated out of hedged international exposure into unhedged equity exposure. Japan has been the major exception. Japanese inflows have been choppy, unlike the steady inflows into other regions. The July 3rd local Tokyo election – where Koike, the leader of the new Party of Hope, won – was a shock to markets, the incumbent LDP party, and led to sizeable outflows during that week and subsequent months. Equity market positioning appears to have steadily weakened since with outflows continuing through September. Despite the solid economic and market outlook, it appears many investors may have already positioned their portfolios in anticipation of future political risks.

Bank of Japan
accommodation continues...

...Which could support equity markets

Chart: Bank of Japan balance sheet


Source: Thomson Reuters, October 11, 2017.

Chart: Japan Yen trade weigthed index


Source: Thomson Reuters, October 11, 2017. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Bank of Japan accommodation continues...

Chart: Bank of Japan balance sheet

Source: Thomson Reuters, October 11, 2017.

...Which could support equity markets

Chart: Japan Yen trade weigthed index

Source: Thomson Reuters, October 11, 2017. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Conclusion

We see several reasons potentially supporting Japanese equities including currently attractive valuations, improving earnings outlook, and continued BoJ accommodation. In addition, weak investor positioning could be reversed with a market friendly outcome. Political risks appear overblown, in our view, and strong fundamentals are likely to prevail. We believe Japan’s competitive export position and improving domestic fundamentals may continue to support the earnings growth at home and abroad, while the risks of yen strength currently appear limited as the BoJ’s monetary policy diverges from a normalizing Federal Reserve and a looming step change in the ECB’s monetary stimulus.