Japanese equities are less talked about, compared to US or Chinese equities. The probable reason is many investors associate Japan with “the lost decades”, “the bursting of the bubble in the 1990s”, and so on. “Cheap valuation” seems to be the permanent description of Japanese equities.
However, for those who have taken chemistry lessons before, you will remember that some amazing chemical reactions can get triggered once you have the appropriate catalysts!
Indeed, in May, Japan’s TOPIX index hit its highest level since 1990, benefitting from a number of catalysts. Since the start of April, net inflows from foreign investors have reached nearly USD 30bn, according to the Tokyo Stock Exchange (TSE), which represents some of the largest inflows of the past decade.
So what are these catalysts for Japanese stocks? And how can investors position themselves on a 6-12-month horizon?
Strong economic data
First, Japan’s economic data has been strong. The country’s Q1 2023 GDP grew at an annualised 1.6%, robustly exceeding expectations of 0.7% gain. Private consumption, which makes up more than half of the economy, grew 0.6% (beating forecasts of a 0.4% increase) as the country's re-opening following the pandemic boosted service sector spending. Capital expenditure also exceeded expectations, rising by 0.9% vs. a forecast contraction of 0.4%.
This is a refreshing change from the concerns about growth in other developed markets, such as the US, as well as the underwhelming activity indicators from neighbouring China. In fact, there is a growing view that one can get exposure to China through Japanese equities, given the latter’s relatively less geopolitical risks compared to their Chinese counterparts.
Improving corporate governance
Another key catalyst for Japanese equities is the Tokyo Stock Exchange’s drive to encourage companies to improve their corporate governance, one of the historical Achilles heel for Japanese equities. Many companies are buying back shares, untangling often complicated cross-shareholding structures, and engaging more closely with shareholders before their regular public meetings. Buybacks announced across corporate Japan surged to an all-time high of USD 71.4bn in the financial year that ended in March, and the size of the buyback is expected to increase further.
Not overcrowded yet
Despite these positive developments, most global fund managers are still underweight Japanese equities. In fact, a majority of the global fund managers have spent more time underweighting Japanese equities over the last five years, compared to other major equity regions, such as the US, Europe and Emerging Markets.
Japanese equities are also undervalued, trading at a 12-month forward P/E of 14x, and at a 10% discount to the MSCI All-Country World index - both below their long-term averages.
The main risk factor in Japan comes from a potential strengthening of the Japanese Yen. With Japan’s inflation on the rise, reversing decades of disinflation, there is a growing risk of a potential tightening of the Bank of Japan’s monetary policy. Any tightening is likely to lead to an appreciation in the Japanese Yen, hurting profitability of export-oriented Japanese companies. Therefore, we see an opportunity to invest in Japanese equities without hedging currency risks, to take advantage of any Yen strength.
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