After intense interest from global investors brought the Topix index up 51 per cent in 2013, Japan has once again become a contrarian trade, with the market slightly down year to date.
As 2014 coincides with the 25th anniversary of the all-time high of the Japanese stock market, we now find reasons to be positive on the country’s market.
Our rationale is based on the depressed valuation which accompanies a good earnings picture.
The Japanese prime minister Shinzo Abe released his Japan revitalisation strategy programme last month.
The main points include a reduction in corporate taxes from the current 36 per cent level to less than 30 per cent over the next several years; public pension reform (including a new government pension investment fund portfolio benchmark); deregulation via special national strategy zones (agriculture and medical care); structural reforms such as the Trans Pacific Partnership and demographic reforms.
We view the structural and institutional reforms – third arrow – as an added bonus, but not the main catalyst in the short term.
The first two arrows of the reform were fiscal and monetary stimulus, which were introduced last year.
We do not expect the third arrows reforms to come in at once and believe that managed expectations are the best way to approach any investments which have to do with the third arrow.
From a valuation perspective, with a forward price to earnings of 13.0x, against 15.4x for the S&P, Japanese earnings are cheap.
For the Topix Core 30 Index, comprising 30 of the largest companies out of the stocks listed on the first section of the Tokyo Stock Exchange, it’s 11.6x. The dividend yield is higher despite a lower payout ratio. Valuations are especially cheap compared to bond yields.
That matters because the pressure is on domestic institutions to shift to equities, especially as real yields are significantly negative and further Bank of Japan easing will keep them so.
Forward 2014 earnings outstripped guidance by 7 per cent. In the last earnings season, seasonally adjusted earnings hit new highs.
The market is effectively trading at multiple compression levels – depressed valuations and good earnings. We believe that the latest numbers show that cost discipline is finally paying dividends.
In conclusion, Japanese equities stand to benefit most from any upside surprises, especially with price earnings multiples back to where they started in late 2012.
While the fundamental backdrop looks better for smaller cap equities, the significant de-rating of larger cap equities makes them a potentially interesting way to position for stronger global growth and a pickup in Japanese exports.
The global macro backdrop has not been especially supportive of the Japan macro trade.
Most notably, the drop in US yields and weak US dollar have been a drag on dollar-yen, which has probably played at least an indirect role in the underperformance of Japanese equities.
The break in the relationship since April 2014 onwards was mostly due to the fast money leaving the market, as the initial heightened expectations of the first leg of the Abenomics trade have faded.
We believe that the fundamentals drivers will start to work again as multiple compression is at play, and Japanese stocks should eventually follow earnings growth and rerate.
Cesar Perez is the chief investment strategist for Europe Middle East and Africa at JP Morgan Private Bank
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