Japanese equities have enjoyed an encouraging first-half of the year, gaining support from more consistent levels of economic growth. GDP came in at 1.0% in 2016, while consensus forecasts for 2017 and 2018 are 1.5% and 1.0% respectively. In the current year, growth is likely to be largely attributable to exports, with capital expenditure (capex) and consumption expected to assume the role of key GDP drivers in 2018. Capex is currently running at around the 5% level, which is approximately double that of the five-year average.
An additional factor that can often be exaggerated in terms of importance is the role that yen strength and weakness can play in determining the direction of Japanese equity markets. Over the last decade or so the inverse correlation between yen appreciation and equity market performance has been quite pronounced. The most recent example of this became evident during the first-half of 2016, when the currency appreciated from a level of 110 yen to the US dollar to around 100 and the equity market retreated - apparently in response.
However, in the preceding 25-year period, the occurrences of such a scenario were very much the exception rather than the rule. To quote the late and legendary Sir John Templeton ‘the four most expensive words in the English language are this time it’s different’. In accordance with this four-word mantra, investors look for reasons to justify the emergence of a recent phenomenon and the yen / equity correlation is no exception. For example, we often hear that, since Japanese companies have such high overseas sales, yen depreciation is positive as it will result in higher repatriated earnings. But, the reality of the situation is that many Japanese companies had been preoccupied with growing market share domestically until comparatively recently. While the percentage of overall sales has subsequently increased to around 35%, this is hardly sufficient to justify the relatively nascent yen / equity relationship.
This year, the yen is consistently trading around the 111 to 112 level. With the US Federal Reserve seemingly committed to both raising interest rates and reducing its balance sheet – a somewhat divergent policy path to that of the Bank of Japan – we anticipate that the yen is more likely to weaken from here, which could prove supportive for the Japanese economy overall. However, we are mindful that FX levels can vary for any number of reasons, including economic, political and geopolitical factors. Therefore, while we will monitor the potential impact of yen appreciation on certain Japanese stocks, we prefer to focus on companies that are capable of enhancing their competitive position, regardless of FX movements and stock correlations.
From a bottom up perspective, the stock picking environment has been somewhat unsupportive in recent weeks, as the factors driving the market appear to have flip-flopped somewhat arbitrarily. From week to week, we have seen ‘value’ come to prominence, only to be usurped by ‘momentum’. And, during periods of relatively strong performance, high beta stocks have rather inevitably come back into favour, albeit temporarily. As a result, we have seen relatively low trading volumes, with many investors choosing to remain on the side-lines as a by-product of the lack of rational directionality.
The one notable absentee from the list of drivers is corporate earnings. But, we are optimistic that the impending fiscal first-quarter reporting season (three-month results to June 30) will catalyse a return to a more fundamentally driven market environment. In this respect, it is worth reiterating that, notwithstanding relatively uninspiring GDP numbers, the corporate landscape in Japan is surprisingly vibrant. Japanese companies are, on average, generating growth in earnings per share of around 7-8% per annum over a three-year cycle. Furthermore, one of the most stringent criterion we apply in selecting stocks for our ‘Japan Leaders’ strategy is a return on equity of 10% per annum; we are continuing to selectively find companies with dynamic management that are capable of performing to this level.
In overall, terms we believe that valuations look unusually compelling, trading at a forward earnings multiple of 13.5x, especially given that fundamentals appear solid. With Japanese equity indices having lagged those of Europe and especially the emerging market complex in 2017, this could prove an attractive entry point. The fiscal first-quarter results season may also provide a compelling opportunity for bottom-up stock pickers to exploit any earnings-related valuation anomalies.