the exception of a brief setback in mid-November, Japanese equities gained ground steadily to record a rise of 8.7% for the quarter. The yen moved in a relatively narrow range against other major currencies and ended little-changed over the quarter, although the market return to a sterling-based investor was reduced slightly to 7.7%.
After considerable initial uncertainty over the potential outcome of October’s snap general election, the likelihood of an LDP (Liberal Democratic Party of Japan) victory increased steadily, enabling equity investors to form a view on the likely continuation of both monetary and fiscal policies. This more stable sentiment was matched by a significant pick-up in net purchases of Japanese equities by foreign investors which helped to maintain upward momentum in the market after Mr Abe’s election victory was confirmed.
After a couple of months out of the headlines, North Korea reignited geopolitical risk in November with a further long-range missile test. There were no obvious signs of constructive engagement from any of the interested parties, making any resolution of this issue difficult to forecast.
The latest quarterly corporate results season continued the strong trends seen in the previous three months as the majority of companies again exceeded expectations and the positive cycle in earnings revisions was maintained. Individual share prices reacted positively to any evidence of improved pricing power as Japan exits a long period of deflation.
After some slightly disappointing economic numbers seen in November, virtually all the data released in December exceeded expectations. The unemployment rate declined to 2.7%, a new low for this cycle, while the number of people employed extended the rising trend seen throughout 2017. Inflation data also unexpectedly improved and industrial production and retail sales were comfortably ahead of forecast. Meanwhile, the Bank of Japan’s quarterly Tankan survey recorded the strongest sentiment among large manufacturing companies for more than 11 years.
Having seen gradual but persistent improvements throughout 2017, Japan’s economy is entering 2018 in relatively good shape and this is reflected in robust corporate profit growth. Although some of this has already been discounted by investors in 2017, expectations for the strength and duration of this cycle are being extended, leaving room for valuations to rise further from here.
The main political events which could shape domestic policy this year include the end of Mr Kuroda’s current term as governor of the Bank of Japan in March and the expiry of Mr Abe’s term as leader of the LDP in September. We currently see no serious challenge to either of the incumbents. In the absence of any significant domestic political uncertainty we would continue to see the main risks to Japan being external.
The merger of property investor Kennedy Wilson Europe Real Estate (KWE) with US-quoted real estate group Kennedy Wilson completed in the period. Kennedy paid a premium price to acquire the remaining shares in KWE that it did not already own – it had retained a majority shareholding after originally floating the business off in 2014.
Although we expect no change in policy from the Bank of Japan in the near term, the ongoing improvement in the domestic economy is leading to growing speculation about how and when the authorities might declare that Japan has exited deflation on a sustainable basis. The mechanism for any subsequent tapering of monetary policy is unlikely to affect our views on individual stocks or their long-term profit potential, but could have implications for overall market sentiment and foreign investor activity. At this stage we would still expect any moves towards an implicit normalisation of Japan’s monetary policy to provide a positive environment for equities, however as with any forecast, it cannot be guaranteed.
The Fund outperformed the benchmark in the quarter mainly as a result of positive contribution from sector allocation.
The strongest individual stock contribution came from SK Kaken, a small cap paint manufacturer which recovered after underperforming over the previous six months. Nippon Thompson also had a positive impact after rising sharply in late December.
These gains were partly offset by a negative impact from KDDI, a major telecom operator, which declined in December, in line with the whole sector, on fears of increased competition. Hi Lex, a small cap auto parts supplier, also underperformed.
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