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Japan’s re-opening has thus far been very supportive for growth.
JAPANESE equities have been on a tear in recent weeks, with domestic equity indices hitting decade highs. Both the Nikkei 225 and Topix index have rallied and are up 18.6 and 14.3 per cent year-to-date respectively (in local currency, as of May 23, 2023).
Before the breakout performance, risk appetite across developed markets has been badly hammered. Mounting concerns regarding the rapid credit tightening, the US debt-limit risk, and a slew of mediocre economic data across the region weighed on investors’ sentiment.
This drove many investors to Japanese equities which exhibited rosier economic prospects and firm corporate fundamentals. Other positives such as a push for corporate reforms and a potential exit from decades of deflation further amplified Japan’s attractiveness against other markets.
In a way, this rally has re-assured our call for Japanese equities. We have been positive on Japan since last year and, more recently, have also doubled down by upgrading the country from 3.5 Stars ‘attractive’ to 4.0 Stars very attractive’.
For our discretionary portfolios, before the rally, we also raised our allocation to Japanese equities, bringing it to five per cent overweight. Moving ahead, Japan remains one of our top equity market picks and in this article, we highlight the key reasons why.
Consumption has rebounded after Japan relaxed measures and is now at 91 per cent of its pre-covid trend.
Our expectations remains aligned with consensus – Japan to deliver relatively stronger growth in 2023.
Japan: Attractive upside with a potential turnaround in 2H22
Japan’s re-opening has thus far been very supportive for growth. Inbound visitors have rebounded by more than 2,400 per cent year-on-year over the past 12 months, fuelling a 336 per cent growth in tourism spending, a driver of consumption, in the same period (as of March).
Despite the dramatic rebound, inbound tourism spending is still 88 per cent of its pre-Covid level and will likely grow as tourism is on track to top pre-covid levels. Domestically, heightened inflation does little to harm spending.
Japan’s consumption has rebounded steadily, even in real terms, and is now at 91 per cent of its pre-covid trend based on our estimates. Another sign that the consumption fuel will not empty soon is the improving consumer confidence. Japan’s Consumer Confidence Index has been on a solid rebound this year, with April’s reading hitting the highest level since February 2022.
Private consumption, which makes up roughly two-thirds of Japan’s GDP, will be a key driver of Japan’s growth this year. We expect a consumption-led growth this year, which should keep the Japanese economy resilient at a time when global growth is softening.
To be clear, Japan’s economic growth will likely moderate in 2023 due to softer global economic momentum, but unlikely to decline as much as other developed markets. Overall, a comparatively better economic outlook should support relative performance for Japanese equities.
Solid corporate balance sheets, complemented with resilient earnings outlook
Corporate balance sheets for many Japanese companies are in a strong position. Cash reserves have risen substantially over the past 10 years as operating conditions improved after the GFC.
For instance, from FY12 to FY22, net margin expanded from 2.3 to 8.5 per cent, corporate earnings profit grew 370 per cent, corporate tax rates were slashed from 38 per cent to 30.6, and borrowing costs fell drastically under BOJ’s negative interest rate policy. This has led to a near 250 per cent surge in cash and cash equivalent during the time.
As of end-2022, close to 50 per cent of Japan-listed companies are net cash (cash and liquid assets in excess of total interest-bearing debt), more than double that of US and European-listed companies. With our base case for a US-led recession, we think Japanese companies are well buffered by the strong cash-rich balance sheet which they can deploy to defend operating performance and quickly recover operations.
Despite the challenging backdrop, close to 55 per cent (122 out of 223) of Nikkei 225 constituents managed to either beat or deliver earnings in line with expectations in the previous quarter.
As such, earnings estimates have held up well in recent months, with the forward 12 months EPS estimates improving. The rosier corporate earnings outlook for Japanese equities is also reflected through higher estimated earnings growth for FY23 and FY24.
Aggregate cash and cash equivalent for Japanese equities have risen substantially over the past decade.
Table shows forecasted earnings growth rates (FY23–FY25) across major equity markets.
Valuations continue to trade at a discount
Valuation for Japanese equities remains cheap. The Nikkei 225 index is still trading at almost seven per cent discount to its long-term average, in terms of the consensus forward PE ratio.
Beyond absolute valuations, Japanese equities continue to trade cheap relative to global equities, and most developed equity markets.
Cheap valuations, both absolute and relative, also imply that: investors are getting exposure to cash-rich Japanese companies at a steep discount; there is a margin of safety entering a global growth slowdown; and valuations have further scope for normalisation, despite the recent rally.
Currency tailwind from a yen reversal
We expect the yen to climb higher against major currencies this year due to a likely normalisation of monetary policy (resulting in higher JGB yields), mounting domestic/ financial pressure on the BOJ, and a re-direction of flows back to the yen.
Historically, a weaker yen has proven supportive for Japanese equities, largely through the boost in earnings. While this is true, we think a stronger yen should not detract from Japanese equities’ performance this time given the positive spillovers.
First, a yen strengthening should help quell macro risks such as the trade deficit and corporate headwinds like high import costs. Second, a strengthening also adds to total returns for foreign investors.
Lastly, a stronger yen can renew overseas investors’ optimism toward Japanese equities. Additionally, a yen strengthening will take place at a time when the currency is significantly weak relative to history.
As such, a strengthening might not have the same drawback as an appreciation when the yen is around the historical average.
Markets are pricing in an eventual abandonment of the YCC and higher policy rates.
A brighter longer-term picture
Corporate reforms are quickly gaining traction. The Tokyo Stock Exchange (TSE) has now joined the likes of Japan’s Liberal Democratic Party in pushing for better corporate governance.
In particular, the stock exchange is now pressuring companies with low PB ratios to more efficiently use capital or potentially be delisted. This has sparked a drastic shift in corporate behavior over the past few months as many companies have responded with buybacks and improvement measures.
With the TSE joining the push for corporate reform, its indicative of policymakers’ long-term desire to encourage greater participation by local and foreign investors by boosting shareholder value. Corporate reform momentum should intensify moving forward, supporting the case for Japanese equities.
Potential to re-emerge as a semiconductor powerhouse. Tensions between the West and China over the global chip supply chain have motivated companies to re-establish and strengthen the supply chain in Japan.
Many of the world’s biggest chip makers like Micron, Intel, TSMC, and Samsung Electronics, have made plans to invest in Japan, such as the building of manufacturing plants and R&D centers.
Japan stands out as an attractive destination due to its generous subsidies, developed infrastructure, existing expertise, and skilled labor force.
The government is also pushing to grow the domestic semiconductor industry. Japan’s industry ministry targets to triple the sales of companies manufacturing semiconductors to 15 trillion yen by 2030.
With both external and domestic push for Japan’s semiconductor industry, we see the potential for accelerated growth in the coming years. While this may take time, we expect significant positive spillover on both an industry and economic level.
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