The calendar year of 2018 proved a difficult one for investors in most asset classes and Japanese equities proved no exception with the TOPIX slumping almost 18% in local currency terms - its worst annual performance since the Global Financial Crisis1. This is partly a reflection of elevated expectations following a bumper 2017, when the price of risk assets was driven relentlessly higher by a heady combination of synchronised global economic expansion and the low cost of capital.
As proved the case in the US, October’s sharp correction in the Japanese equity market was clearly led by growth stocks, as the prospect of rising bond yields caused investors to question the wisdom of holding positions in the most expensive sectors of the global equity market. Although it is tempting to state that Japan has merely suffered from external contamination, this would, in reality, be a slight oversimplification. We cannot possibly infer that trading tensions between the US and China will have no impact whatsoever on the Japanese economy or the profitability of its corporations. However, according to the International Monetary Fund (IMF), Japan is far less vulnerable to the fallout than many other emerging and developed nations, as illustrated below.
IMF estimates of the impact of trade tensions on real GDP
As such, it is no surprise that the IMF recently upgraded Japan’s economic growth forecast for 2019 (+0.2%), while downgrading that of developed economies in aggregate (-0.1%). This begs the questions as to whether the Japanese stock market was unjustly punished in 2018 and might this provide an attractive entry point? The answer to both these questions lies in deeper fundamental analysis.
At the beginning of 1995 (five years after Japanese equities had peaked in price index terms), the market still traded at a forward price / earnings ratio (P/E) of 56x3 while the forward P/E of the US market was a much more reasonable 12.5x3. Similarly, as global equity markets enjoyed a post-crisis bounce in 2009, Japan continued to trade at a massive premium (32x3) to the US (14x2). However, in recent years this dynamic has reversed dramatically.
The forward P/E of US equities is now higher (15.4x3) than that witnessed in 2009, while the Japanese market trades at a significant discount (11.7x3). Those who follow markets closely may be aware that, prior to 2018, Japan had been enjoying a buoyant bull market for more than five years, so what could have caused such a seismic shift in relative valuations?
The interesting point is that the formation of valuations owed more to art than science in the past. Japanese equities – especially during the bubble years of the 1980s, were driven more by powerful psychological influences, such as intuition, instinct, and herding (among others). One of the reasons for this can be attributed to the high ratio of cross-shareholdings that characterised the Japanese equity market in former times. For example, in 1990 this ratio stood at 35%4, but had declined to 9.5% by 20174 and is expected to fall further in the coming years due to the impact of enhanced corporate governance. We believe the time is right for markets to be priced in accordance with aggregated valuations which interrelate to the growth and quality of earnings. On this basis, Japanese equities appear compellingly attractive.
Remarkably, the forward P/E of the Japanese stock market traded at a significantly higher level in mid-2013 (14x3) than it does today. This effectively means that, throughout much of the 2012-17 bull market, Japanese equity prices failed to keep pace with the growth in corporate earnings, while investors over-rewarded US corporations for under-delivering (in relative terms) over the same period.
While animal instincts almost inevitably lead to distortions, fundamental dislocations invariably correct with the passage of time. This is not just true across regional markets, but at the sector level, and within it, too - witness the explosive outperformance of technology shares and the incredibly narrow leadership within the US equity market in recent years. A similar dynamic has been evident in Japan and, while we could make a relative argument for favouring passive exposure to Japanese equity indices over their US counterparts (in P/E terms) we believe that fundamental investing can add considerable value.
From a thematic perspective, growth momentum has been moderating in various manufacturing sectors, particularly smartphone and automation-related areas, global recession risks appear low based on steady private consumption which should be sustained by solid real income in core countries. Labour markets should remain tight, potentially lifting wages, and a lower oil price should keep inflation contained. In Japan, the consumption tax is expected to be hiked from 8% to 10% in October 2019. In order to limit the negative impact, the government intends to implement an economic stimulus package ahead of the consumption tax hike alongside measures such as shopping vouchers or tax cuts / subsidies for new vehicles.
One of the investment themes we are looking at for 2019 is the turnaround of the machinery sector. In recent times, this industry has been heavily hit by concerns over the global growth slowdown and Sino-US trade friction. However, based on previous experience and earlier trends (as illustrated below), we believe the trough may be seen early in Q2, 2019 or even late Q1. We have confidence in the structural growth of the machinery sector because factory automation is needed not only to counteract labour shortages but also because many of the products and electronic components have become increasingly fine-tuned and require high-grade production techniques. This work can no longer be undertaken by human beings - mechanical precision is essential.
Machine Tool Orders Japan (year-on-year)
Past performance is not an indicator of future performance and current or future trends.
Moreover, if our overall scenario of sustained, solid private consumption proves to be correct, manufacturers (who currently seem to be holding back on necessary investment in areas directly impacted by trade frictions) will be forced to increase capital expenditure once more in order to handle final consumer demand. Strategically, we maintain our view that listed firms should be able to sustain annual profit growth in the high single digits for the foreseeable future. Japan remains at the forefront of technological innovation, especially in robotics, and we believe that futuristic themes, such as artificial intelligence (AI) and the internet of things (IoT), will continue to catalyse new business opportunities and more efficient work processes.
In addition, consumer demand is expected to remain robust due to the evolution of technologies such as 5G and the cloud. Meanwhile, trends in electric motorisation, the automated operation of automobiles and cashless settlement (the latter being government driven) are expected to accelerate.
Although the growth potential for Japanese corporate earnings in 2019 is expected to be lower than last year, the earnings trend of the stocks we consider to be ‘leaders’ is robust. In stark contrast to this, the stock market seems oversold, especially in relation to smartphones and factory automation. In overall terms, the stock market appears to have excessively discounted a global recession.
Consequently, the possibility of an upward market re-rating appears high in our view, while, at the stock level we continue to see truly compelling opportunities to invest in companies that we believe can repeatedly grow their earnings at a decent pace, yet selectively trade at undemanding valuations. Our philosophy is predicated on exploiting what we consider to be the durability of strong earnings growth from leading companies relative to prevailing share prices – this is a discipline that rewards patience and investment conviction. As such, we are mindful of not paying too much attention to short-term noise as such distractions could potentially undermine our core strength.