20th May 2013
Dan Morris, global strategist at J.P. Morgan Asset Management has issued a note discussing the depreciating yen and its impact on equities including asking whether returns on equities could reach the levels of other developed markets.
The yen has broken above ¥100/$ and the Nikkei topped 15,000 for the first time since early 2008. Since mid November, the MSCI Japan Index has gained 75% (though ‘just’ 37% in US dollar terms). A lot of this, however, is simply catch up. From the bottom in global equity markets in March 2009 through last November, Japanese equities were flat while developed markets outside Japan (represented by the Kokusai index) had advanced by 77%. Even with the rally since November, the MSCI Japan Index still lags developed markets by 16% (see Figure 1).
Last data 17 May 2013. *MSCI World ex-Japan. Source: MSCI, Bloomberg, J.P. Morgan Asset Management.
This gap is one reason to believe that there is still room for the Japanese market to continue rising. Another is that the yen may depreciate further, and the currency’s fall has been the principal driver of the stock market over the last six months. Even at ¥102/$, the currency is not particularly weak, at least in nominal terms. From 2002 to 2007 the currency ranged from ¥100/$ to ¥125/$. It was only as investors sought out the yen as a safe haven during the crisis that it appreciated to ¥75/$ (see Figure 2). The depreciation we have seen since is part of the generalised decline in risk aversion, mirroring falls in the price of gold and yields for European peripheral government debt. Since the currency is merely returning to its ‘natural’ range, G7 leaders have so far not been unduly concerned by the fall.
Last data 17 May 2013. *MSCI World ex-Japan. REER = Real Effective Exchange Rate. Source: MSCI, Bloomberg, J.P. Morgan Asset Management.
But is the currency enough to drive longer term stock market outperformance? Probably not. A drop in the price of exports will lead to a one off increase in the level of sales but does not result in continually rising sales. And while the yen can continue to fall for a while, its decline will be limited by the supply of dollars from quantitative easing (QE) in the US. Even without QE, the currency is not going to weaken forever. What then are other sources of superior price returns?
One source would be a revaluation of the market as multiples expand. It is not clear, however, that the Japanese market is particularly cheap. Multiples reached such extreme levels during the stock market bubble (nearly 50x earnings), that comparing price-to-earnings (P/E) to historical averages does not offer much insight as PE ratios will likely never revert to the average. Using to P/Es over a shorter period, however, may be more helpful. From December 2000 to today, forward P/Es were at least below 30. Currently the index is trading at a 7% discount to that average, a little better than the 1% discount for the Kokusai index. Relative to other markets, Japanese equities have always traded at a premium. This has averaged 1.20x since 2000 and it is 1.15x today (see Figure 3). So a revaluation of the market is unlikely to drive an outperformance of Japanese equities.
Last data 17 May 2013. *MSCI World ex-Japan. Source: IBES, FactSet, Bank of Japan, J.P. Morgan Asset Management.
Another source of price gains would be investor demand. Japanese households have maintained the level of ownership of shares traded on the Tokyo and Osaka stock exchanges at around 20% for almost 20 years (see Figure 4). Interestingly, foreign investors have been increasing their share even as the market has returned less than equities elsewhere. With new policies from the Abe government and the Bank of Japan re-launching QE, Japanese equities could become more attractive to both sets of investors. Recent fund flow data suggests this may be happening. Foreigners have invested more into the market just through mid May than they had for any full year since 2006. Domestic investors (both households and institutions) are also becoming more bullish. Since 2001, net non-Japanese equity investment was positive, that is, Japanese investors bought more foreign equities than they sold. This year, in contrast, they have been net sellers, assumedly redirecting some of that equity allocation to domestic stocks. If foreign and domestic investors increase their weightings in Japanese equities, the incremental demand would provide a boost to the market.
Last data December 2012. Source: IBES, FactSet, Bank of Japan, J.P. Morgan Asset Management.
The key driver for long-term outperformance will ultimately have to be better earnings growth. Tellingly, analysts have not been revising upwards company long-term earnings growth rates as they have been for earnings estimates benefitting from the yen’s depreciation. Japanese corporations are currently much less productive than their counterparts in the US or Europe. Expected return on equity (ROE) is just 8.3% in Japan vs 12.4% in Europe and 15.6% in the US. The recent attention of some hedge funds on a few Japanese companies show that the potential is recognised. If Japan could increase its ROE to even European levels, on current multiples the market would be nearly 50% higher than it is today. The Nikkei at 22,500 would certainly bring some cheer to investors, but it is unlikely to be reached easily or quickly.