Active Thinking

At GAM Investments’ latest Active Thinking forum, Ernst Glanzmann discussed the impact of the Ukraine-Russia conflict on Japanese equities and reflected on some favourable tailwinds for the sector.

21 March 2022

Ernst Glanzmann – Japan Equities

Directly, Japan is largely unaffected by the tragic Ukraine-Russia conflict. Russia makes up only 1% of Japan’s exports and 2.4% of its imports, predominantly liquified natural gas and some coal. However, most of Japan’s oil imports come from the Middle East which accounts for 10.1% of imports, meaning there is little impact from this point of view. The impact on Japanese companies are primarily higher commodity and energy prices.

The best case scenario is that the conflict will be short lived, but we fear it could be a long and lasting issue. However, we believe financial markets have passed the shock phase and are moving towards an adaptation phase where corporates will have to figure out how we live in this new world and create strategies to work around issues such as higher commodity and energy prices, and how to pass that on to clients and consumers. This will be a gradual process, but we believe it will be more easily facilitated as the cause is broadly understood, and price increases will therefore be more broadly accepted. Should the conflict persist, and commodity prices increase further, this will have a longer term negative economic impact and the risk of recession will begin to increase. This environment creates a lot of uncertainty and we would expect it to weigh on household spending, which we believe will have a slight dampening impact on GDP growth in Japan.

The current uncertain environment has led investors to concentrate on stock holdings with immediate earnings security in the face of rising commodity prices, rather than solid companies with earnings prospects two or more years from now. As there is selling pressure on quality names in Japan, valuations on these stocks have come down to 15 times, levels last seen in 2018 during the Trump – China trade war. However, they have not yet reached the valuation levels we saw following the global financial crisis.

Beneath all the noise, fundamentally there are some positive themes in Japan. The manufacturing sector still shows signs of recovery as supply chain disruptions ease as restrictions on movement of people both domestically and abroad are gradually removed. However, a severe lockdown in the Shenzhen area of China negatively impacted Asian markets due to concerns over short term supply issues.

Both Covid-19 and the Ukraine-Russia conflict have created a favourable tailwind as it has sparked interest in the renewal of production machinery, modernisation, fuel efficiency and decarbonisation which will be good for the capital goods sector in Japan generally. Both world exports and machinery orders remain strong, as are the orders of numerical control machine tools, which are essentially the brains of robots. There has even been a slight pick up in China’s orders of metal cutting machine tools showing that, despite all the noise surrounding the Ukraine-Russia conflict, demand is still there.

Another tailwind for international Japanese companies is the weakness of the yen due to divergence in central bank policies. The change in the yen at the sales level is of greater weight than the yen change at the cost level in the income statements.