Japanese equity outlook: five questions answered
Diverging monetary policy between the US and Japan and uncertainty around internal politics have driven volatility in Japanese equities, but what’s the long-term outlook?
Autheurs
Japanese equities have been very volatile over the past three months. Initially this was driven by diverging monetary policies between the US and Japan (see What’s behind the stock market sell-off? ), which prompted a rapid unwind of Japanese yen ‘carry trades’ (where investors borrow in yen and invest in higher yielding foreign assets) and a sharp currency appreciation. Latterly, uncertainty around internal politics was the driver of equity market volatility (see chart, below) culminating in a snap general election called for 27 October. However, despite these short-term challenges, the strategic long-term reasons for investing in Japanese equities remain unchanged explain Taku Arai, Deputy Head of Japanese Equities, and Masaki Taketsume, Fund Manager, Japanese Equities.
The market see-sawed during the process to elect a new prime minster – can you give some context for these moves?
Taku Arai: “Markets were initially unnerved by the unexpected victory of veteran politician Shigeru Ishiba in the run-off with Sanae Takaichi to be the next leader of the ruling Liberal Democratic Party (LDP) and Japan’s next prime minister (PM).
“This can be viewed as a reversal of the so-called ‘Takaichi Trade’, when we saw a weakening yen and rising stock prices in the last week of September in anticipation of her proposed expansionary fiscal policy and commitment to continuing monetary easing. These policies were very much in line with the ‘Abenomics’ of former LDP leader PM Shinzo Abe, which had been gradually adjusted by the previous PM and LDP leader Fumio Kishida.
“In contrast, Ishiba, who is known for fiscal reconstruction and for considering an increase of financial capital gains tax, was viewed with caution by the market.”
Ishiba has called a snap election for 27 October - how should investors interpret this development?
Masaki Taketsume: “History has shown that positioning portfolios around who you think is going to win an election is almost always a losing strategy, and it is always important to have a diversification of risk.
“This is not to say that we ignore the potential policy risks, but we believe it is more important to remain focused on the outlook for the economy, the direction of interest rates, the forecast for earnings growth and the relative attractiveness of valuations.”
Taku Arai: “In this regard the fundamentals of Japanese companies and the domestic economy are robust, and corporate earnings remain strong. Corporate earnings and macroeconomic figures showed solid progress in Japan throughout Q3.
“Aggregate quarterly earnings from April to June exceeded expectations. The weakening yen supported this performance, while domestically focused sectors also demonstrated a robust recovery.
“Real wage growth, taking inflation into account, turned positive for the first time in 27 months in August and its positive momentum continued in September.”
With the odds of the LDP winning the election being favorable, how do Ishiba’s polices stand versus those of his predecessors?
Taku Arai: “Ishiba has commented that he intends to inherit Kishida’s economic policies as the base line for his administration.
“His new cabinet looks to have a solid line-up and is anticipated to continue to promote wage increases to stimulate domestic demand. Meanwhile, a supportive stance for normalising the Bank of Japan’s (BoJ) monetary policy could help reassure long-term investors.
“Regarding his intention to increase financial capital gains tax, this is unlikely to severely dampen the flow of savings into investments, which has been supported by the renewed NISA (Nippon Individual Savings Account) tax free investment scheme for individuals.
“In addition, positive efforts are expected to continue regarding a policy plan for promoting Japan as a leading asset management centre as well as ongoing corporate governance reforms, which the Kishida administration had focused on.”
The BoJ’s unexpected July rate hike contributed to the sharp appreciation in the yen and equity market volatility – how should long-term investors view a stronger yen?
Taku Arai: “The BoJ’s rate hike reflected confidence in Japan’s macroeconomic development, including wage growth. It also mitigated some of the risk of further yen weakness, which could have driven higher inflation in Japan – so, overall, it was a positive for long-term investors.
“That said, a stronger yen cannot avoid exerting downward pressure on the earnings outlook for export-related companies.
“In terms of domestically focused companies, as already mentioned, real wages have shown positive growth for two consecutive months, raising expectations for a recovery in consumption.
“Companies will report their first-half financial results later this month at which time the outlook for corporate earnings for next year will become clearer.
“If the domestic oriented companies maintain their strong earnings progress, market sentiment could stabilise.
“More specifically, if the earnings resilience of small and mid-caps focused on domestic demand becomes apparent we may see some performance pick up from these stocks.”
So, to recap, what are the key aspects of the outlook for Japanese equities that long-term investors should hold in their mind?
Masaki Taketsume: “Robust corporate fundamentals, improved governance standards and increasing demand from foreign and domestic investors.
“Many domestically oriented companies are demonstrating strong demand and signs of regaining pricing power (the ability to raise prices in response to inflation) for the first time in decades. After years of entrenched deflation, the importance of this should not be underestimated.
“When coupled with improved consumer purchasing power through wage increases, this should drive healthy levels of corporate earnings growth.
“Some of these higher profits can then be recycled back into the economy through further wage increases, driving a positive cycle of broader economic progress that has been largely absent from Japan for a generation.
“Meanwhile, due to the ongoing efforts by the Tokyo Stock Exchange, corporate governance reforms have continued. While the recent volatility underlines some uncertainty around policy directions by the new Ishiba administration, these reforms are now resulting in growing interest from the global investment community, following a long period of overseas apathy towards Japanese equities.
“In addition, there has also been an increase in the level of Japanese retail participation in the equity market as a result of the NISA scheme. NISA came at an ideal time, just as retail investors started to recognise a shift towards a more inflationary environment in Japan and thus the need to move money out of their bank deposits and to rotate it towards investment in the equity market.
“Share buybacks, in particular, have also continued to increase as the market has risen and we would expect this to continue as more companies are compelled to improve their returns and address their persistent undervaluation.”
Autheurs
Topics