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Weaker yen strengthens Japan

Currency easing and attractive valuations are leading the way for an upward trend in Japanese share prices

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We are in a very positive phase for the Japanese market. Companies are doing well, analysts are behind the curve and, as a result, earnings’ forecasts are being revised higher.

In turn, these upward revisions are driving share prices. Japanese companies are benefiting both from the sharp adjustments they have made to their cost bases and from good operating performances. These welcome trends seem likely to continue.

The key factor behind the Japanese market’s outperformance over the year to date has been the weaker yen. A weaker yen is, of course, positive for Japan’s export-driven economy and there is a very strong case to be made that the yen will weaken further from current levels.

It seems probable that the Bank of Japan will be slower to raise rates than other major central banks. It is even possible that the BoJ will reintroduce quantitative easing and/or other aggressive anti-deflation strategies.

In contrast, central banks in the West are, in effect, tightening monetary policy by calling an end to quantitative easing. As the interest rate differential between Japan and other developed economies widens it will exert considerable downward pressure on the yen.

Encouragingly, we are already starting to hear talk of Japanese households increasing their purchase of Australian bonds – this so-called “carry trade” heralded the last major phase of yen weakness.

But investing in Japan at this juncture is not merely a warrant on the future direction of the yen. Overall, Japanese stocks remain very cheap.

With earnings still recovering from depressed levels, price-to-book ratios offer the best valuation perspective. On our numbers, the Topix currently trades on a price-to-book ratio of around 1.1 times – a 35 per cent discount to its longterm average.

We have started to see signs that the economic recovery has broadened out from the original V-shaped improvement in industrial production. The labour market is also showing signs of improvement

The supply/demand balance also looks supportive. Certainly, the risk of further equity issuance continues to weigh on the market but a renewed bout of foreign buying seems equally likely. International investors remain the dominant marginal participant in the Japanese market and they remain heavily underweight.

If investors take steps to close that underweight, buying could be significant. Surveys show that global investors recently turned net buyers of the Japanese market.

We have started to see signs that the economic recovery has broadened out from the original V-shaped improvement in industrial production.

The labour market is also showing signs of improvement. The number of overtime hours worked has started to rise, and incomes, while still falling, are declining at a slower pace than before.

This is consistent with comments from Japanese companies, which imply they might have overdone cost reductions in late 2008. Some are starting to increase the number of shifts they offer employees. In turn, this can help to place a floor under consumption, which has been badly hit by weakness in the labour market and falling incomes.

Japan should have performed well last year – historically, it has performed well in the early stages of the global economic cycle. That it didn’t was largely due to the strength of the yen coupled with political uncertainty.

As a result of this disappointment, many foreign investors reacted emotionally, dumping Japanese stock without regard to fundamentals.

Despite that disappointment, the headwinds that slowed Japan’s progress last year are easing. With the yen weakening, the political situation stabilising and valuations at attractive levels, all the ingredients are in place for Japan to play catch-up with other markets.

John Millar is fund manager of Martin Currie Pacific Trust

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