Japanese share prices could yet benefit from a return of inflation neurosis. Over the last 15 years, Japanese equities have underperformed the S&P 500 by more than 200 per cent (in local currency terms). However, over those 15 years, Japan experienced several short-term bull markets. Between May 2005 and February 2006, for example, Japanese equities rose almost 50 per cent – five times the growth in the S&P 500 over the same period. We find ourselves wondering if we are approach-ing one of these events.
Many factors have been supporting the case for Japanese equity outperform-ance in recent weeks:
- Japan is a high-beta/risk play on the global recovery – historically, Japanese earnings are most impacted by the global economic output cycle. As global output continues to expand, this should support strong earnings momentum.
- The Japanese economy is most likely to benefit from global reflation – Japan has experienced deflation for most of the last decade. Global reflation pressures, while concerning many national central banks, such as those in emerging markets and the eurozone, should support the Japanese economy without causing an immediate tightening by the Bank of Japan. From 1980 to 2009, Japan has outperformed global equities 73 per cent of the times when US bond yields were rising (reflecting higher inflation and growth).
- Valuations for Japan relative to global equities are becoming more attractive – Japanese equities have almost always attracted a premium but that premium has been reducing in the last few years. On a composite of valuation metrics (forward price to earnings, price to book, dividend yield), Japanese equities seem cheap – the 12-month forward p/e for Japan relative to global equities is at a 20-year low.
- Japan is showing signs of corporate activity – Japanese corporate free cashflow yield for 2011, estimated at 9.2 per cent, is the highest for any region. There have been early signs that corporates are putting this cash to use (through increased dividends, share buybacks and even M&A activity). A more shareholder-friendly corporate sector is a big positive.
Investors have been taking note and fund flows into Japan are occurring at a rapid pace. Asset allocators have also been reducing their underweights to the region. However, out-performance typically occurs following a catalyst – the 2005 rally, for instance, coincided with the re-election of president Koizumi.
Historically, a weakening of the yen has also proved the springboard to a rally. This could happen again, particularly if short-dated US bond yields move higher, or the recent events in the Middle East and North Africa continue to increase global inflationary pressure. Another possibility may be more shareholder-friendly corporate activity as earnings continue to be supported by the recovery and Japanese corporates continue to benefit from China’s phenomenal economic power.
We are keeping a close eye on market events and are ready to add to exposure if policy turns more stimulative or corporate earnings are materially upgraded at the financial year end.
Bill O’Neill is chief investment officer of Merrill Lynch Wealth Management, EMEA