There is a perception that, having shown signs of life earlier in the year, the Japanese equity market has disappointed once again. However, the reality is somewhat different.
The Tokyo Stock Exchange First Section index (Topix) has risen by 5.7 per cent in sterling terms since the start of January – significantly ahead of the Morgan Stanley Capital International World index, which has returned 3.3 per cent, and rather more than the 5.3 per cent delivered by the FTSE All Share index, also in sterling terms.
One important indicator of the health of the equity market is the number of new share flotations or initial public offerings by companies. On this basis, the Japanese equity market is in robust health. More than 100 firms have launched themselves on to the market since the start of the year – admittedly, half the level seen at the recent market peak in 2000 but still a very encouraging figure.
A wide range of companies are approaching the market and, if the recent trend continues, this could be the second-best year for initial public offerings, ahead of the 169 in 2001.
What has been driving the market and helping to produce this better equity performance has been the improving economic situation in Japan. After a decade of constant disappointment and economic stagnation, investor sentiment was very depressed. Renewed signs of life, in the form of statistical data which firmly suggested that Japan was emerging from the economic mire, were very welcome and sentiment quickly turned around as the pace of growth improved.
Official statistics revealed that economic growth was running at an annual rate of over 6 per cent, consumer spending was rising and so too was corporate investment. In a supportive environment of more or less synchronised economic growth around the world led by the US and China, investors took the view that prospects for Japanese companies and its equity market were much improved.
So far this year, investors have allocated a net £38bn to the Japanese equity market, mainly at the expense of areas of perceived slower growth such as continental Europe.
But more recent economic data has been less encouraging and this has made the headlines. The level of economic activity in Japan has undoubtedly slowed, consumer spending is not recovering to the extent that had been hoped, government spending is lower and demand for exports, particularly technology-related, is tailing off.
Meanwhile, the pace of growth in the US and China has also eased back slightly. In the US, the higher oil price, high levels of consumer indebtedness and a stormy last few months have combined to produce early signs of a reduction in the rate of economic growth.
We are still expecting moderate economic expansion but the pace of growth will undoubtedly be slower for the moment. The situation is similar in China, where measures taken by the authorities to calm an overheating economy, by restricting lending among other things, appear to have been successful and the rate of economic expansion has eased to a pace which is still rapid but perhaps more sustainable over the medium to long term.
The net effect will be to remove some of the external stimulus from the Japanese economy and, in turn, from its equity market. Over the last couple of years, the focus of Japanese trade has shifted away from the US towards China, where demand has been stronger and which has the advantage of being geographically close. Any change in economic activity in the US will still have an effect but less so than previously.
Yet although we accept that the pace of growth in Japan is unlikely to be as robust as it was earlier in the year, we remain positive on the prospects for the economy and equity market.
Business confidence, as represented by the Bank of Japan's Tankan survey, is at its highest level for almost 12 years and, while we may see a period of slower growth in Japan in the short term, over the medium to longer term we would expect economic growth to recover.
While the market as a whole may struggle to make sustained progress in the short term, we expect to continue to see new investment opportunities appearing at the stock and the sector level, even in this slower growth environment.
A key feature of the Japanese equity market is still the fact that it is under-researched by many big broking houses, particularly as you move away from the very biggest companies into less well known names. This means that investors prepared to spend time investigating promising companies which have been overlooked by some of the biggest investors have scope to add significant value.
We are upbeat on selected domestic stocks, financials and defensives but more cautious on basic materials and technology companies, which could start to see the effects of slightly weaker demand. Our focus remains on well managed companies with strong cashflow and the potential to generate better than expected earnings once growth picks up again.