Some countries look better than others in today’s global bull market. For example, Europe may suffer from market jitters at the possibility of a Greek debt default and US equities are facing the twin headwinds of a higher dollar and pressure on margins.
By comparison, Japanese equities are unlikely to be buffeted in the same way. With one of the lowest correlations to global equities of any major developed market, diversification benefits could be a reason to reconsider Japan.
The Japanese equity market has had an excellent start to the year: the Nikkei 225 is up by more than 12 per cent year-to-date and reached a 15-year high at the beginning of April. In stark contrast to other recent rallies, this year’s gains have not been accompanied by a significant further depreciation in the yen. There are reasons to think the market will remain well supported in the short to medium term.
The most obvious attraction of the Japanese stock market is also the most longstanding: it looks cheapagainst other developed markets. Even though the Nikkei 225 has risen by 180 per cent since the low point in March 2009, it remains one of the only developed markets still trading below its 10-year average on a price-to-earnings ratio basis.
Japan’s deep-seated economic challenges should give pause to any long-term investor. Indeed, Japan has been cheap on most traditional metrics for a long time and many would say for a reason. However, we see several forces that might lead to a positive change.
The first is improving corporate earnings. Japan had stronger earnings momentum than any other major developed economy in Q4 last year and experienced particularly strong earnings growth when compared with the UK, US and eurozone. Some 67 per cent of companies in the Topix beat earnings expectations, the highest in five years, and earnings per share grew by 8 per cent year on year (excluding energy companies).
Flows should also be a clear positive. The equity market should benefit from strong demand from the official sector this year. To start with, the Government Pension and Investment Fund needs to invest tens of billions in the Japanese market to comply with its revised mandate to invest 25 per cent in domestic equities. In addition to this, the Bank of Japan is expected to invest $25bn as part of its expanded programme of asset purchases. If even a small proportion of the $4,800bn invested in the domestic pension fund and insurance industry follows these institutions into equities, the impact on the market could be significant.
A third positive is improving corporate governance on the back of long awaited reforms. The BoJ and the GPIF will invest through a newly created index, the JPX Nikkei Index 400, composed of companies meeting global investment standards in terms of return on equity and corporate governance. The fact these investments will be published regularly will encourage companies to improve their governance and put more emphasis on shareholder returns by maximising their ROE. Rising dividend payouts offer some evidence that reforms to corporate governance are having an effect and Japanese companies are starting to treat investors differently.
Fourth, cheaper oil is a tailwind behind Japanese equities. Given the lack of domestic energy resources, Japan’s energy imports are one of the highest among advanced economies. In particular, the consumer discretionary sector should benefit from consumers having more money in their pockets. That sector can power the market upward, as it accounts for 22 per cent of MSCI Japan versus only 12 per cent of the S&P 500 and 11 per cent of MSCI Europe. Likewise, energy only accounts for 1 per cent of the MSCI Japan index compared with around 8 per cent of the S&P 500 and 4 per cent of MSCI Europe, so the dampening effect on earnings should be less.
There have been too many false dawns in Japan for any investor to consider its stock market to be a “sure thing” and given the depth of the country’s structural problems it is certainly too soon to call Abenomics a success. However, attractive valuations, decent earnings momentum and continued structural support for Japanese equities from official purchases provide a fertile environment for future growth in the market.
Stephanie Flanders is chief market strategist for UK & Europe, J.P. Morgan Asset Management