Japanese equities have outperformed their US counterparts in both USD and local currency terms since mid-2016 and Japan’s corporate earnings have risen 25% to record highs in the past six months. Nevertheless, the country’s equities remain under-owned and present one of the few compelling opportunities for longer-term investors seeking growth at a reasonable price.
US economic data has been disappointing through much of the first half of 2017, while Japan’s GDP beat expectations in the first three months of 2017. Meanwhile, PMI data shows resilient demand both in Japan and in international markets.
Unemployment is a mere 3% and for the first time since the mid-1970s, Japan’s female employment rates, at 66%, are above those in the US (64%), spurred on by Abe's reforms, see graph, right.
Meanwhile, as US policy-makers continue to grapple with fiscal policy, Japan’s successes in boosting the female workforce, along with an increase in infrastructure spending in preparation for the 2020 Olympics in Tokyo, have combined to create a supportive fiscal backdrop for the country.
These dynamics are finally coming through in the economic data. Consumer confidence has reached a four-year high and retail sales growth has accelerated to its fastest rate since 2015. Similarly, corporates are recovering from their long slumber and beginning to increase their own capital spending plans as the labour market tightens.
Underpinning the recovery
Previous shoots of economic recovery have often been stifled in Japan, but this time round policy-makers are keen to support the turn-around. Having stymied growth with a hike in sales tax during 2014, the government has delayed the next round of sales tax increases to 2019. What's more, the Bank of Japan looks set to keep policy unchanged until at least next year, with core inflation still below target.
This contrasts with hopes for fiscal policy stimulus in both the US and Europe, with the prospect of a tightening bias from the US Federal Reserve and an end to monetary easing from the European Central Bank.
With a growing and deepening economy, Japanese corporates are seeing favourable tailwinds to earnings. Since November 2016, earnings have risen 25%, while first-quarter corporate earnings were at record levels, up 16% year-on-year. This is while 80% of companies beat their own forecasts and almost two-thirds outperformed consensus forecasts. These results have been underpinned by near-record net profit margins and strong free cash flow generation, almost unheard of in Japan a decade ago.
Against a backdrop of strong global corporate earnings, Japanese earnings expectations of +11% in 2017 compare favourably with the +12% earnings growth expected in the US. Admittedly, European corporate earnings expectations of +19% are more impressive, though these are buoyed by outsized weights in energy and materials sectors compared with Japan.
Despite this momentum, Japanese corporate earnings forecasts haven’t yet reacted to this improved potential. One factor restraining a more optimistic earnings outlook are forecasts of a $/¥ rate of 108, close to the 2016 average level and stronger than the 110-115 levels seen for much of the first half of 2017.
Even with these constrained expectations, Japan’s TOPIX index trades at a modest 13.8x earnings compared with 16.6x in the US. Indeed, investors are paying near-historically low relative price-to-book value multiples compared with corporate earnings power (return on equity) looking back to the early 1990s.
Corporate Japan’s rising dividends and continuing buybacks will be key to closing the gap with global counterparts. Dividend growth has been rising steadily since the Abe-inspired reforms of 2012. Similarly, corporate buybacks, a staple of free cash flow deployment among US corporates, have been rising in Japan since 2012, from less than ¥2 trillion in 2012 to over ¥5 trillion in 2016. With capex beginning to absorb a growing share of Japanese corporate free cash flow, the pace of buybacks has understandably slowed in 2017.
Many view a weakening in the $/¥ rate as necessary in order to generate positive returns in Japanese equities, given the strong correlation in recent years, and there is reason to believe that the yen strength seen so far this year is nearing an end. Over the past year, Japanese financial institutions have become ‘over-hedged’ against a backdrop of widening yield differentials between the US and Japan. US growth is likely to rebound in the second half of 2017, reversing the trend of a flattening US yield curve, which has been in evidence since February this year. Against this backdrop, a combination of ‘over-hedging’ and a further widening of yield differentials should begin to turn the tide on the $/¥ rate in the months ahead.
Buoyed by global growth
Therefore, on a cyclical basis, we view Japan as both cheap and a clear beneficiary of the current recovery in global growth. Banking and autos sectors present particular opportunities as both have lagged the TOPIX in 2017 and at 9x PE are the cheapest of large TOPIX sectors.
Looking beyond the cyclical story of Japan, the country’s corporate sector appears well-placed to benefit from some of the key secular trends in the Asian region, as well as the world.
Many investors are looking to large, listed technology names in the US to benefit from the next generation of disruptive industries such as robotics, artificial intelligence, virtual reality and biotechnology. However, global investors can focus on Japan to tap companies at the forefront of these trends.
At the same time, tourist dollars are boosting Japan’s businesses in ways that could not have been foreseen 10 years ago, thanks to the reduced cost of regional travel and the relative cheapness of visiting the country. Figures from the Japan National Tourism Organisation show visitors from China, Taiwan and Hong Kong rose from 1.8 million in 2006 over the entire year to almost one million per month in 2016.
Greater China’s tourists benefit from the high-end brands and niche consumer goods that both countries desire, as well as Japan’s far-sighted energy policy, established in the 1970s, which has provided a relatively healthy environment for pollution-shy visitors.
In summary, as investors begin to look further afield from the multi-year outperformance of US equities, we believe Japanese counterparts present much more than a weak yen play for investors. Instead, Japan offers attractive value against a backdrop of accelerating earnings growth and an increasingly expensive US equities market. It also provides an opportunity to diversify portfolios geographically, while continuing to maintain exposure to the growing set of disruptive technologies that are changing the global economy on a secular basis.
CIO Private Banking