23rd February 2015
Japanese stocks are up more than 60% in local currency terms over the last two years and there is potential for further gains this year. Stephen Cohen, chief investment strategist for iShares EMEA, looks at four factors that could drive further gains…
The market’s focus this year has been geared towards Europe, but Japanese stocks have moved steadily higher, and few investors have noticed. There are four factors that could spur a further rally in Japanese equities. As always, investors need to look at the direction of the Yen and our preference is to use a currency hedged approach.
1. The Bank of Japan could surprise again
The Bank of Japan’s ‘QQE2’ in October 2014 was a catalyst for easing the build-up of pressure on the ECB and other central banks. Recent talks suggest the BoJ could do more, especially as a lower oil price makes its commitment to a 2% inflation target by the end of this year a challenge.
More than this, the BoJ risks losing credibility if it does not act. Recent statements from Kuroda-san suggest a significant willingness to deliver whatever is needed. Whilst recent speculation has focused on July as a potential announcement date, Kuroda-san is known to surprise on timing. The monthly monetary policy meetings until then are worth watching closely. As the BoJ is already buying 250% of the net Japanese government bond (JGB) issuance, focus would likely be on other assets such as ETFs, J-REITS and even outright equities.
That said, dissenting voices have become louder in recent weeks, putting into question the benefits of further QQE, and shedding light on growing investor concerns around JGB volatility – the bigger the QQE size, the more difficult the exit.
2. There is continuing momentum following GPIF’s allocation shift
Greater allocation towards risk assets by the Government Pension Investment Fund (GPIF) catalysed Japanese equities last year. In a bid to achieve its real return target of 4%, the GPIF handed out active stock mandates to four Japan-based asset managers. A further sign of its increasing focus on risk assets was the appointment of Hiromichi Mizuno, a former private equity executive, as the fund’s first chief investment officer.
The $3.7trn Japanese pension market and retail investors have followed GPIF’s asset allocation shift too. This is reflected in the record pace of JGB selling and greater domestic and foreign equity buying. The net impact is a weak yen due to the starting point of Yen-denominated bonds, alongside equity strength.
3. The stable political environment could push through more ‘arrows’, with a focus on growth-friendly corporate reforms
There is a stable political environment following Abe’s landslide victory in the lower house, and this means he has room to focus on the ‘Third Arrow’ – reforms aimed at improving economic productivity. Following last year’s sales tax hike, focus has shifted to more growth friendly corporate reforms. A corporate tax cut of 2.5% to 32.1% should boost company profitability and there could be room for more cuts.
The creation of the Nikkei 400 index triggered a shift towards more shareholder responsibility. This has led to greater shareholder-friendly corporate measures, including an increase in share buybacks and dividends. Investors will likely reward such companies, and we are seeing speculation about a group of ‘next 400’ companies, striving to improve ROE and dividend payouts in order to qualify for inclusion.
4. Japanese stocks are cheap on an absolute and relative basis
Despite posting the highest total return of any market in 2013, and a further 6% in 2014, strong earnings growth has kept Japanese equities trading at cheap valuations. Markets expect earnings per share to grow 7% this year, despite headwinds faced by energy producers. The latest earnings season has continued to beat expectations, and strong earnings growth has kept valuation multiples attractive as Japan’s stock market trades at 14.2x price/earnings vs 15x for developed markets. A weaker yen should also continue to support the earnings outlook for Japanese exporters.
Investing in Japanese equities is not without risks. Although the short yen trade is no longer crowded, long Japanese equities is still popular. Any loss of momentum may trigger a correction similar to that in January 2014. The yen has also become a safe haven currency at times of crisis and often it appreciates versus the dollar even on risk-off days. This creates a risk of downward pressure on Japanese equities in any risk-off move, given the correlation between a stronger yen and weaker equity. A global growth slowdown would also be a tail risk. Should this materialise, Japan could be amongst the first impacted as it is highly geared towards global growth.