3. China’s index dominance crowds out alpha opportunities
The 2023 forecast for real GDP growth in Japan is amongst the highest of other developed markets at
+1.8%.1 There should be a degree of resilience in the face of global slowdown pressures. Meanwhile
inflation is showing signs of slowing
after hitting a 41-year high of 4.2% year-on-year in January. Still, it is well above the Bank of Japan's 2%
The yen has fluctuated strongly over the last year or so, first weakening to 150Y/USD in October 2022, a level
not seen for more than 30 years, and subsequently strengthening back to the current 130Y/USD levels. A weaker
yen is on average positive
for Japan’s stock market’s earnings, but this impact has declined over time, as Japan’s
corporates localised production overseas; it is positive for exporter’s earnings, but negative for
domestic companies and consumer.
The market was taken by surprise by the Bank of Japan in December when they announced an increase to the upper
band for 10-year Japanese Government Bonds. This has led to a stronger yen and possibly sets the scene for
further monetary policy tightening
in 2023, especially if the current Bank of Japan Governor turns more hawkish.
Japan’s corporates are still very competitive globally. We are not concerned about the yen strengthening
towards its longer-term average level as our valuation models use the 110-120 range. A more stable yen backdrop
will hopefully persuade
international investors back to Japanese equities after having been absent for the last three years.
4. What is the corporate profits’ outlook and where are you
In the near term, the boost from the domestic re-opening, resilient consumers, the normalisation of the Chinese
economy, and the recent hikes in wages are tailwinds for Japanese corporates. The normalisation of supply
chains, lower commodity and logistics
costs, and the ability to pass-through higher cost to consumers should also be positive for profits. Margins are
improving and the long-term upward trajectory for earnings remains intact.
Excess savings and pent-up demand will benefit the domestic mall operators while the continued removal of global
supply constraints will help manufacturers, especially the auto companies. Companies in the inbound tourism
space are expected to benefit
alongside steel and chemical companies catering to the recovering Chinese demand.
Separately the recent sell off in Japanese financials is largely due to revised market expectations of a flatter
Japanese yield curve, not a result of contagion fears. The team continues to favour banks that will benefit from
restructuring and cost
efficiencies, manage their interest risks well, and do not actively use hold-to-maturity securities.
5. Why invest in Japan now versus other developed markets?
Japan is the world’s 3rd largest stock exchange by market capitalisation. It is also a very
liquid, deep, and broad market with over 2000 listed companies. Japan has outperformed other developed markets
in terms of earnings per share
growth over the last 10 years. Yet it is one of the most neglected, under-appreciated and under-owned markets.
The Japanese equity market was down -4% in 2022 in yen terms. This was a ‘relatively’ decent
performance compared to other developed markets which were down nearer -20% in their respective local
currencies. This resilience was due to a
late Covid reopening, a weaker yen and the fact that Japan did not have the same magnitude of growth stock
excesses that markets like the US experienced in the prior years.
Valuation is another strong reason; Japan remains cheap versus history and other markets. Despite strong earnings
revisions and improved companies’ fundamentals, the market did not re-rate and is trading at very
attractive valuations versus
global peers. A point to note is that lower starting valuations are supportive of likely future outperformance
for the market.
Corporate governance reforms have also prompted cost cutting, balance sheet restructuring, more efficient capital
allocation and resulted in rising dividends and share buybacks, all of which are underpinning shareholder value.
In our recent conversations
with company CEOs, it feels like we are perhaps entering a new phase for Japan, with higher prices and rates -
time will tell how persistent these forces will be.
Over the longer term, Japanese companies are at the gateway of Asia ex-China, where they can both facilitate and
partake in Asia’s growth story via the finance, retail, and consumer goods growth, but also by means of
supporting factory automation,
infrastructure, and energy transition.
6. What key risks are on your radar?
The biggest risk is a deceleration of corporate governance reforms, but we see good momentum and multiple drivers
pushing this forward in a sustainable fashion. Such drivers are government support, unwinding of
cross-shareholdings, increased shareholder
activism, corporate restructuring that contributes significantly to a company’s financial sustainability,
employee motivation, and shareholder returns. Other shorter-term risks are obviously recessionary risks, with
Japan being a cyclical
market, but fundamentals seem more resilient now.
Investors are prone to biases and markets are subject to periods of irrationality where value will deviate from
price (e.g., Covid lows in March 2020 or the extremes of technology valuations in 2021). Indiscriminate sell
offs typically present opportunities
where the excessive short-term pessimism results in one underpricing a company’s long-term earnings.