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Japan: 29 years after the crash

GAM Investments’ Carlo Capaul and Ernst Glanzmann analyse how the Japanese equity market has evolved over the last three decades from both technical and fundamental perspectives.

9 October 2018

‘Cruise around the town with a gold steering wheel, I'm hooked on having fun’ as the Japanese rock / pop girl band Princess Princess (commonly referred to as Puri-Puri), sang in 1989. The US pop icon Prince would doubtless have described such lyrics as a ‘sign of the times’, with Japan enjoying a so-called economic miracle that had endured for three decades, propelling the nation to the status of the world’s second-largest economy. The wealth effect spawned by stock and real estate prices soaring to stratospheric heights undoubtedly fuelled the party spirit, but the music stopped playing abruptly on 31 December 1989.

Chart 1: Performance of MSCI Japan Gross Total Return Local Index

 
Source: Bloomberg in JPY as at 30 September 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.


At this point, the market was trading at 51.1x earnings, having entered the 1970s at a modest P/E ratio of 11.1. Something had to give and it did. According to the MSCI Japan (gross dividends reinvested) index, yen and Swiss franc-based investors have yet to see their late 1989 investments in Japanese equities restored to parity, but the material devaluation of all other currencies has ensured that most long-term investors have, thankfully, not suffered the same fate. Given this historical context of reversion to peak levels by virtue of a strong upswing in the Japanese equity market that began in 2012, some investors might come to the conclusion that caution is warranted and ask where we stand now?

In a nutshell, we are living in a very different investment world compared to that of 1989. From an evolutionary perspective, it is fascinating to note that investors in Japanese equities are now exposed to materially different sector risks than at the peak of the market. Financials and IT companies are of much less importance than at the end of the 1980s, while the industrials, consumer discretionary, consumer staples and telecommunication services sectors have gained more influence.

A further aspect of Japan’s evolution is that a large number of leading Japanese companies are much more integrated with the global economy than at the beginning of the 1990s. As a consequence, the Japanese equity market exhibits a much higher correlation with the global equity market these days, as illustrated below, and long periods of underperformance appear less likely than in the past.

Chart 2: MSCI Japan versus MSCI World: Trailing 5 year Correlation

 
Source: Bloomberg, based on monthly total returns in JPY, gross dividends reinvested,as at 30 September 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.


However, from a fundamental perspective, the extent of this correlation actually underrates the performance of corporate Japan. Over the last 10 years, listed firms have grown net earnings per share by 9% per annum. This is almost double the speed of listed companies in the US. Today, interestingly, the US market trades at a trailing price-earnings ratio of 21 times and Japan only on 13 times. While US equities have once again demonstrated their resilience during 2018, there is no doubt as to which of these two markets appeals more in terms of valuation.

As chart 3 illustrates, a similar valuation case for Japan can be made in comparison to global equities. Despite the devastating stock market collapse Japan witnessed at the very beginning of the 1990s, Japanese equities have remained expensive for much of the ensuing period. But that is no longer the case.

Chart 3: Comparison of Price/Earnings

 
Source: Bloomberg as at 30 September 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.


Furthermore, Japanese equities also trade at a discount based on other valuation metrics and have been doing so since the end of 2013. Interestingly, this period coincides with a strong rally in Japanese equities and demonstrates that rising share prices have simply failed to keep pace with rapidly improving fundamentals.

For historical comparison, the dividend yield of the index stood at 0.5% when the market peaked in 1989. At that time the global dividend yield was around the same level as today (c 2.4%), while the dividend yield on Japanese equities has increased to 2.2% over the same period. Clearly, Japan trades at a premium on this measure, but that premium has virtually been erased and a poor dividend yield is no longer the investor deterrent it once was.

And crucially, profitability has improved materially during the same period. The return on equity differential, relative to the global equity market has reached a very low level now compared to that seen throughout the preceding three decades.

Chart 4: Comparison of Return on Equities

 
Source: Bloomberg as at 30 September 2018. For illustrative purposes only.

Past performance is not an indicator of future performance and current or future trends.


From a fundamental perspective, we believe that the profits of Japanese firms could grow around 8% per annum over the next few years despite on-going trade disputes and financial market instabilities in emerging markets. Overall, information derived from companies suggests that a steady expansionary path is likely to continue.

Combine this with the historic low valuation metrics and it is quite intuitive why we believe we are now at an attractive entry point for strategic investors. Although Japanese equities have rallied strongly in recent years, we believe the fundamentals are sufficiently robust to suggest that the ‘boat has yet to set sail’.

Overall, we feel we can confidently suggest that Japanese equities are worthy of an above-benchmark weight in global portfolios. This has yet to be reflected in aggregate positioning, but for how much longer?

 
Important legal information
 
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.