Schroders: Good times for Japanese equities

The euphoria in Japanese equities that we witnessed in 2013 was somewhat tempered this year as stock prices in Japan came to terms with a raft of disappointing economic data following a consumption tax increase in April.

The correlation between the Japanese yen’s weakness and rising stock prices continued to drive the market later in the year and the TOPIX index is in positive territory year-to-date. The consumption tax hike in April – which saw an increase from 5% to 8% – contributed to slowing growth, the extent of which become apparent by two consecutive quarters of negative GDP growth (in real terms) for the second and third quarters.

Taxes and elections

The headline-grabbing news for Japanese stocks came in a flurry of announcements. First, there was late October’s ramp-up in the Bank of Japan’s quantitative easing (QE) programme as it announced plans to significantly increase its purchase of Japanese government bonds (JGBs) as well as risk assets, Japanese equity ETFs and J-REITs (real estate companies). And only a few weeks later Prime Minister Abe announced a postponement to a consumption tax originally planned for October 2015 and called a snap election for December 2014. The 18-month delay of the second consumption tax increase – which will see it go from 8% to 10% – means the rise will be implemented in April 2017 without any further postponement. There was also positive news in October when Japan’s government pension fund, GPIF – the world’s largest of its kind – announced a reduction of its bond portfolio by allocating more positions to Japanese and global equities. 

As a result of these developments, the yen has continued on its depreciation trend while the stockmarket received a boost from the end of October in to November.

Resilient economy

Despite the recent setback after April’s consumption tax hike, evidenced by an unexpected two negative quarters of GDP growth, we remain positive on the improving trend of Japan’s economy. The tightening labour market continues to suggest constant wage growth, which we think will support the inflationary trend that the Bank of Japan has targeted. Given that the second consumption tax increase has now been postponed we believe the benefits of higher wages over the next two years will start to feed through to the real economy and that this will result in a solid recovery in domestic consumption next year. Furthermore, the country’s listed firms are more resilient than one might assume. Japanese companies are expected to derive more than half of their earnings from overseas operations. Although global growth is slowing, the trajectory is likely to be one of a modest recovery led by the US over the coming years. And within Japan, we are also seeing an encouraging picture. Corporate earnings continue to improve and corporate capital spending budgets are also being expanded, which should hopefully translate into higher growth in domestic demand.

Upside to corporate earnings

As mentioned previously, corporate earnings growth is still expanding at a solid pace in Japan and there are further drivers that will likely see this trend continue. One is the positive impact of yen weakness, which has not been fully realised in company earnings forecasts. Many exporters are still factoring in an average dollar/yen rate of around 100-105 yen – while the current exchange rate stands at around 118 yen to the greenback.

Further positive news for Japanese companies could come in the form of corporate tax cuts, one of the key initiatives in Abe’s growth strategy. With Japan’s rate among the highest in the world’s developed economies, a reduction in the top rate from the current 35% to less than 30% over a period of a few years could continue to support corporate earnings in the medium-term.

More importantly, from a mid to long-term view, we are witnessing landmark advances in corporate governance in Japan. Measures aimed at improving governance include requiring outside directors on company boards, the creation of the JPX400 – an index with quantitative and qualitative criteria, including a higher return-on-equity (ROE) and the enforcement of Japan’s stewardship code. Early 2015 should see continued reform. The Tokyo Stock Exchange will set up a corporate governance code. Reflecting such a development, an increasing number of companies have announced share buybacks to reduce their cash pile and improve ROE. All of the above means that the outlook for Japan Inc. going into 2015 looks encouraging.

Focus on fundamentals

So where will we be looking for opportunities in 2015? Sustainable mid- to long-term earnings and valuations are what we are focusing on when we look at which companies to invest in. This would preferably come through company-specific growth drivers as opposed to just betting on the cyclical recovery or macroeconomic tailwinds such as only on a weaker yen. We are finding cyclical stocks including autos, electrics, and some parts of machinery attractive, given their potential for upward revisions to earnings, while being mindful of valuations. We also like trading companies and financial stocks given their cheap valuations. Turnaround opportunities among out-of-favour stocks are also an area where we see additional investment ideas as we go into 2015. As always, we continue to remain disciplined and strictly adhere to our bottom-up stockpicking approach, leveraging our in-house fundamental research platform on the ground.