Japan: capitalizing on the pullback

Authors: Julia Wang, Cameron Chui, Yuxuan Tang, Weiheng Chen
 

After a stellar first quarter for global markets, investor sentiment turned more cautious in April. Over the last few weeks, markets have been digesting macro risks emanating from inflation surprises in the U.S. and continued geopolitical uncertainty. 

After a meaningful rally earlier in the year, these risks have sparked a sell-off in global equity markets in recent weeks. At the time of writing, the TOPIX index has pulled back 5.3%, after reaching a 35-year high in late March. 

We believe the recent pullback creates an even more compelling buying opportunity for investors seeking to participate in the regime shifts occurring in Japan. Sectors that stand out to us include financials, consumer discretionary (excluding autos), technology, industrials and real estate. Meanwhile, the Japanese yen (JPY) has weakened to a fresh cycle low of over JPY155 to the dollar on the back of a resurgent USD. We believe the JPY may remain weak for some time yet, and we advocate for USD-based investors to hedge potential JPY weakness or borrow yen to fund an equity position. 

Reflation still on track

In our update two months ago we wrote about Japan’s emergence from three decades of deflation, and the generational opportunity this brings to Japanese assets. To recap, Japan’s economy and markets stand to benefit from a constructive mix of global and domestic tailwinds:

• Inflation has returned and the economy is normalizing, which is boosting confidence as the long-held deflation psyche finally breaks.
• Globally, the shifts in supply chains coupled with technological trends in semiconductors benefits Japan’s economically important manufacturing sector.
• The backdrop of higher U.S. interest rates and a persistently stronger USD keeps the JPY at a weaker level, helping to further increase the competitiveness of its exporters.
• Fiscally, the government is implementing industrial policy aimed at luring global companies towards investment in Japan’s manufacturing capacity.
• Last but not least, the Bank of Japan (BoJ) is still keeping monetary policy accommodative to support capex and corporate borrowing needs.

These factors continue to underpin our positive thesis on Japan, and recent data has affirmed our view. 

In recent months, corporate investment continues to be an important driver of economic growth. Capex growth remains strong across software, R&D and even land purchases (which have been contracting for two decades). In Q4 2023, investment grew 8% in real terms. 

The corporate outlook remains positive. Corporate surveys suggest executives plan to keep investing – and the recovery in loan demand is evidence of it. After decades of underinvestment, the catch-up in capex could continue to drive growth on a multi-year basis. This is especially timely as Japan is seeking to capitalize on shifting global supply chains and technological trends as a potential beneficiary of heightening global trade tensions, particularly between the U.S. and China. Japan’s government – along with local corporate sectors – are spending billions to reinvigorate the semiconductor business, building on the country’s strength in equipment and materials. Over time, these investments can help to support a recovery in productivity growth, which has languished for years. 

Meanwhile, the domestic consumption recovery has disappointed, as households are still reeling from the squeeze on real wages in 2023 as inflation spiked to multi-decade highs. That said, consumer confidence has recovered to a post-pandemic high, and will likely continue to improve on the back of a positive wealth effect due to rising asset prices and the prospects of higher wage growth, which has finally started to take hold across the economy. 

Does recent financial market volatility, particularly in FX, impact our view?

We believe the BoJ will likely be able to manage those risks and maintain accommodative policy to support continued reflation. In the upcoming BoJ meeting on 26th April, the central bank will likely lower its GDP growth forecast for 2024 slightly, acknowledging the uncertainty in the global economy. Reports suggest that inflation forecasts could also be upgraded slightly – a nod to growing confidence in the reflation path.

However, market volatility, particularly in the currency, has come under the spotlight in recent weeks and is on the central bank’s watchlist. Sharp yen weakness has led some to call for a more forceful monetary policy response from the BoJ, as rates remain deeply accommodative. However, we are skeptical that a sharper tightening is appropriate, and any incremental moves from the BoJ are unlikely to change the fact that Japan has one of the lowest nominal and real rates amongst major economies. On the other hand, premature tightening, if not warranted by economic fundamentals, could risk undermining the nascent growth recovery and reflation progress. Balancing these risks, the BoJ will likely try to keep policy accommodative as it monitors two-sided inflation risks in the near-term. 

What are the Japanese equity themes worth considering?

With a still-supportive macro and policy backdrop, we see now as an opportune time to add to Japanese equities, particularly for the majority of investors who remain under-allocated to Japan relative to global benchmarks.

We expect low-to-mid teens upside and maintain our Topix outlook of 2,900-3,000 by end-2024. Domestic reflation and the weaker yen are expected to drive nominal growth rates higher and we expect 11-13% earnings growth in 2024, plus a further 8-9% in 2025. The Topix is expected to offer some of the fastest earnings growth rates in the developed world over the next 12 months. After the recent sell-off, Topix forward P/E has moderated back to 15x, broadly in-line with 10-year averages. With corporate reform continuing to make progress and management teams increasingly focused on both the return on capital and return of capital to shareholders, multiples have strong potential to re-rate over time.

Our key themes in equity markets are economic reflation and corporate reform. They can particularly benefit specific sectors, namely:

• Financials: With reflation returning, we expect nominal GDP growth to re-accelerate relative to the past two decades. Financials, and particularly banks, are among the most sensitive sectors to an improvement in nominal growth. We see banks benefitting from a) stronger economic activity that likely translates into greater demand for credit; and b) the expectation that the BoJ will likely tighten monetary policy gradually, raising yields and providing another tailwind to bank earnings and profitability over time.

• Consumer Discretionary (ex. auto): Domestic wages are growing at some of the highest levels in over 30 years and we expect this momentum to be sustained as wage growth broadens out and feeds through the economy in the coming months. The increased spending power can drive increased domestic discretionary spending and benefit well-positioned retailers and manufacturers of consumer goods.

• Technology: Japan is one of the global leaders at manufacturing specialized semiconductor capital equipment, components, and tools for the industry. In some cases, Japanese producers have a near monopoly in specific elements of the semiconductor supply chain. With increased capex driven by shifts in global semiconductor supply chains (which benefits Japan), rapidly expanding investments in artificial intelligence advancements, and a nascent cyclical recovery, the sector remains well-positioned for above-market earnings growth in the years to come. 

• Industrials: After an 18-month downcycle in global manufacturing, we are finally seeing signs of recovery via U.S. ISM and global manufacturing PMIs. Historically, Japanese industrial companies that specialize in manufacturing capital equipment, robotics, and machinery see an uptick in new orders that results in accelerating sales and expanding margins when global manufacturing PMIs rise. This group of companies can further benefit from a strong USDJPY that improves their competitiveness versus global peers and leads to market share gains.

• Real Estate: Reflation is driving property prices higher in Japan, particularly in the main economic growth engines like Tokyo. Owners of prime real estate stand to benefit from asset revaluation, property sales, and increased rents. Companies that can find ways to unlock value or improve returns on capital by realizing their real estate gains could see further upside.

Should I be concerned about currency risk?

Domestic reflation beneficiaries tend to be much less sensitive to currency movements, and their fundamentals are more dictated by domestic demand. Thus, for investors concerned about a meaningful appreciation in the yen, we view banks, retailers, and real estate as segments that would be better insulated from this risk compared to export-oriented businesses.

For general allocations to Japanese equities, we advocate for USD-based investors to manage the currency risks carefully by considering the following:

1. Hedge out JPY exposure and enjoy the carry. At the moment the Japanese currency runs a deeply negative carry against the USD. By hedging it back to dollar, investors enjoy a ~5% carry on an annualized basis thanks to wide interest rate differentials, and hedge currency risks from the equity position. 
2. Take JPY loans. Despite an exit from negative interest rate policies, Japan is still the only major economy with near-zero interest rates. By borrowing and investing in the same currency, investors are not taking currency risks.
3. Hedge against further JPY weakness through structures. For investors holding a view that the JPY is undervalued at the current level, structures allow participation in potential medium-term strength while hedging against downside volatility. We believe hedging is necessary, as risks of an extended period of dollar strength cannot be ignored. 

All market and economic data as of April 25, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

There can be no assurance that any or all of these professionals will remain with the firm or that past performance or success of any such professional serves as an indicator of the portfolio’s success.

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For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.

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• Past performance is not indicative of future results. You may not invest directly in an index. 
• The prices and rates of return are indicative as they may vary over time based on market conditions. 
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• The information provided herein is not intended as a recommendation of or an offer or solicitation to purchase or sell any investment product or service. 
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Index definitions

TOPIX also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange.

The Consumption Activity Index (CAI), compiled by using a variety of sales and supply-side statistics on goods and services as its source statistics, is provided as a measure for capturing short-term consumption activity on both monthly and quarterly bases. The CAI traces movements of consumption in the household side of the economy, much like those in the Annual Report on National Accounts (ARNA) -- which represents consumption activity in Japan in the most comprehensive manner -- but is made available in a more timely fashion. The CAI shows only small fluctuations emanating from samples rotations, and also exhibits a high correlation with a number of confidence survey measures.

TOPIX-Banks Index is a capitalization-weighted index of all the banks listed on the First Section of the Tokyo Stock Exchange and is one of the 33 industry sectors of the TOPIX Index (TPX). The index was developed with a base value of 1000 as of January 6, 1992. The parent index is TPX.

The JGB 10-year Index is a Legacy Government (Sovereign) Generic Index-key ticker by Bloomberg L.P. for the Japan Government 10-year bond. 

The Residential Property Price Index is an index of prices of residential plots of land and unit ownership buildings. The index is calculated based on data gathered through the System to Provide Real Estate Transaction Price Data (Land General Information System) operated by the Ministry of Land, Infrastructure, Transport and Tourism (MLIT), with the quality of each property adjusted using the Hedonic Approach.

The Commercial Property Price Index is an index of prices for commercial property (commercial plots of land and buildings) nationwide that is calculated based on the data accumulated through the System to Provide Real Estate Transaction Price Data (Land General Information System) operated by the Ministry of Land, Infrastructure, Transport and Tourism (MLIT), and the quality of each property is adjusted by using the Hedonic Approach.

The J.P.Morgan Global Manufacturing PMI is a composite index produced by J.P.Morgan and S&P Global in association with ISM and IFPSM. This index looks at the manufacturing sector, by surveying output and employment intentions of manufacturers. A level above 50 indicates economic expansion, while a number below 50 indicates a contracting economy.