Sunil Krishnan argues that low expectations among domestic and global investors are reflected in Japanese equity valuations, creating an opportunity for the asset class to play catch-up with the rest of the world.
Two key themes have dominated equity markets in the post-crisis recovery period, particularly in the last five years. One is the dominance of US stocks over other markets, and the other is the persistent weakness of the ‘value’ factor in equity markets. In large part, this has been justified by a stronger earnings profile of companies on the winning side – be they US firms, growth companies or an overlap of the two, for instance in the technology sector.
Interestingly, the last few months have seen a reappraisal of those themes. The relative performance of non-US markets has stabilised somewhat against the US, and global indices of value stocks have performed in line with growth counterparts. The factor has been deeply unloved for several years and is one of the reasons why we find US financials attractive.
The Japanese equity market has some strong value characteristics
The Japanese equity market is another good example. It has heavy weightings to sectors like industrials, technology is geared towards hardware rather than software, and as a result companies show high operational leverage. This means their earnings are more volatile because they have large fixed costs, so small changes in sales lead to big changes in earnings. The last several years of sluggish global growth have thus not been particularly favourable to Japanese company earnings compared to other markets. Weak growth is not an environment where they can outperform.
Figure 1: 12-month forward earnings vs other markets
Low expectations set to unlock value
However, we have reached a juncture where value could be rehabilitated. A long period of weakness in global manufacturing and trade – including a global manufacturing recession for most of this year – has weighed significantly on sentiment towards manufacturing-heavy economies. Applied to companies, this has led to significant downgrades in earnings expectations over the last 12 months. Those have been headwinds for Japan, but the degree of pessimism and the associated valuation discount are such that they have created an opportunity.
To give an example, expectations for the global stock market are that, by the end of 2020, company profits will be more than ten per cent higher than at the end of 2018. In contrast, the expectation for Japanese companies is that profits will be little changed over the same period.
Japan earnings vs world (level terms)
Figure 2: MSCI AC World (earnings in level terms)
Figure 3: MSCI Japan (earnings in level terms)
This is a very low base, increasing the potential for Japanese companies to create a positive market surprise. Crucially, we don’t think this upside surprise potential requires a strong recovery in global activity or manufacturing; stabilisation would be enough. The world economy does not need to improve for that value to be unlocked.
Adding the fact that, in terms of valuations, price-to-earnings ratios are 13 per cent cheaper than elsewhere in the global equity market creates a margin of safety.1 While Japan will perform best in a global economic recovery, those valuations offer a degree of protection if growth is not so strong.
Investors have expressed concern about the impact of the VAT hike in Japan which came into force in early October. When Japan last raised VAT in 2014, it led to a deep recession. Now, a strong Q3 GDP report has added to worries that spending has been brought forward to beat the hikes, driving a steeper fall in Q4 and beyond.
The key difference from 2014 is that, learning from the experience, Shinzo Abe’s administration has prepared a large stimulus package that should take effect in early 2020 and continue past the summer Olympics. We expect this package will provide a boost in excess of one per cent of GDP – which for a large, sluggish economy is material.