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Market Comment  27/11/2017

Taking aim at Japanese Equities

In 2012, Shinzo Abe, leader of the Liberal Democratic Party (LDP) rode to victory in Japan’s general election. He won the backing of the nation on a promise of reviving the country’s stagnant economy and vowed to achieve this using a three pronged, or rather, three arrowed approach – ‘Abenomics’.

He shot off the first two arrows with relative ease, unveiling a large and sustained policy of monetary easing and by announcing a huge fiscal stimulus package.  The third arrow - that of reforms to encourage structural growth - would be more of a challenge to find the target with.  The required reform would be multi-faceted and nuanced: lowering corporation tax, improving corporate governance, increasing the labour participation of women, more openness to foreigners and lowering regulation and barriers to investment.  Support for reform has steadily grown, however, as most Japanese realise that change of some sort is needed.  Following Abe’s landslide general election victory in October 2017, the path for a far reaching and successful package of reforms looks within reach.

Following Abe’s landslide general election victory in October 2017, the path for a far reaching and successful package of reforms looks within reach.

Could Abe’s third arrow be the dagger to the heart of the persistent low inflation, economic malaise that has plagued the Japanese economy for the last two decades?  Possibly.  Employment levels in Japan are impressively high and the recently released 3rd quarter GDP data confirmed the 7th quarter in a row of positive economic growth, the longest such streak since 2001.  Recent growth rates of around 1.5% per annum have been higher than the perceived potential growth rate leading to positive implications about inflation.  That being said, our overweight case for Japanese equities is not contingent upon a strong reflation trade, only an environment of moderate inflation and moderate economic growth.  The export heavy Japanese economy also stands to continue to benefit from the synchronised global upswing in economic activity. 

Japanese corporate earnings have surged under ‘Abenomics’.  Earnings estimates have risen 12% in the last year and Japanese corporates are more profitable now than they ever have been (Chart 1).  Despite this, the Topix 500 is yet to reach pre-crisis levels (Chart 2).  Japanese equities trade on a forward-looking PE that is ‘only’ in-line with their 10-year average PE of around 14x.  This compares favourably to both Europe (Stoxx 600) and the US (S&P 500) that trade on premiums compared to their 10-year average multiples of around 21% and around 24% respectively (source: Goldman Sachs Global Investment Research).

Potential Japanese Yen strength is a risk for Japanese equities, and although we do not view the currency as being undervalued we take some comfort from the fact that should such a scenario unfold the appreciating currency provides a partial hedge from a Sterling investors perspective.  Another risk is that a downturn in the Chinese economy would have a greater impact on Japan than other regions.  However, we believe that any slowdown in the Chinese economy will be drawn out, rather than abrupt, and so will be manageable in the global context.  Whilst being cognisant of these risks, the cheap relative valuations, strong earnings momentum and the good economic backdrop suggest a promising outlook for Japanese equities. Additional tailwinds from successful reform measures, Abe’s third arrow, would also be welcome.

Ewan Millar
Senior Investment Manager

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