Even though foreign sales represent a smaller share of total corporate revenue for the MSCI Japan index than they do for the MSCI Europe index, the key driver for Japanese equity returns since the global financial crisis has been the value of the yen. The recent inability of the Bank of Japan to weaken the yen has therefore resulted in the underperformance of Japanese equities.
Profit growth could in theory provide an alternative source of price appreciation, but sources of rising EPS are hard to find. Nominal GDP growth is still well below that of most other developed economies, corporate margins are declining from historically high levels, and Prime Minister Shinzo Abe speaks little about reforms, the third arrow of his plan to restart the Japanese economy.
Lacking a change in the way the Japanese economy functions, or the way Japanese corporations are managed, it is challenging to see a change in the earnings outlook. One consideration may trump this, however. Valuations for Japanese equities are near record lows on both a price-to-forward-earnings (P/E) and a price-to-book basis (P/B) (see Exhibit 1). Even if earnings growth disappoints in Japan, a reversion to historical multiple norms could provide a boost to the market.
Exhibit 1: Relative valuations, Japan vs. World ex-Japan (Kokusai)
Sources: IBES, MSCI, BNP Paribas Asset Management as of 24 August 2016
Small cap equities may outperform large cap equities if the bulk of the stimulus in Japan remains fiscal as opposed to monetary. Increased spending on infrastructure and welfare, and support for small and medium-sized businesses favour domestically focused small-cap equities. Moreover, if the yen remains strong, export growth will suffer for large cap corporates. While multiples for small cap equities are higher than their historical average, the more promising earnings outlook supports the premium.
The selloff in 10-year JGB yields following disappointment with the Bank of Japan’s announcement at the beginning of August, echoing the US and Germany “tantrums” of 2013 and 2015 (see Exhibit 2). The sharp move highlights how central bank policy is driving government bond yields more than economic fundamentals. Investors are wondering if central banks have reached the limit of what they are willing or able to do as far as extraordinary monetary policy is concerned.From the perspective of inflation, more arguably needs to be done: core inflation is just 0.9% in the eurozone and 0.5% in Japan, and falling in both. Whether the costs of negative interest rates and quantitative easing are greater than the benefits of any boost to inflation or economic growth remains unclear.
Exhibit 2: Tantrum bond yields
10-year government bond yields relative to period lows*
Note: Germany yields relative to 20 April 2015, Japan relative to 27 July 2016, US relative to 2 May 2013.
Sources: Bloomberg, BNP Paribas Asset Management as of 24 August 2016.
If the Bank of Japan in September were to follow Prime Minister Abe’s stimulus package with a big increase in bond purchases (essentially pursuing a “helicopter drop” monetary policy), and if the bank were able to convince investors and the Japanese public that it would hold on to these bonds forever, the outlook for both the fixed-income and equity markets would change radically.
In contrast to declining JGB yields under the current Quantitative and Qualitative Monetary Easing (QQE) programme, bond yields could rise as the dramatic increase in the money supply boosts inflation expectations and hence nominal bond yields. Gross debt-to-GDP ratios will rise (even if net-debt ratios would remain unchanged), adding to concerns about the solvency of the Japanese government and hence boosting the risk premium for JGBs. The yen would likely depreciate, providing a boost to large cap equities. It does not appear likely that this is the path the Bank of Japan will take, but investors should be conscious of the opportunities such a move would present if the BoJ goes further down the QE path. [divider] [/divider]
This article on the investment outlook for Japan was written by Daniel Morris on 24 August 2016 in London
This article is part of our recent ‘Investment outlook’ and ‘Economic outlook’ series.
Here are the links to all the articles: