EQUITY UPDATE - Japan Outperformance
Japan has been the best performing regional market this year up almost 4% in local and USD terms. In September, the Nikkei was up almost 6%, its strongest performance in over twelve months, on the back of a weaker yen, expectations of an earnings upswing and confirmation that Prime Minister Abe would remain the head of the LDP.
After being sellers of Japanese stocks for most of 2018, foreigners increased their weighting in September anticipating a better Q2 fiscal year earnings season that starts at the end of October. On some metrics, Japan Inc. has performed well this year with profit margins at non-financial firms hitting a record 7.7% and return of equity (ROE) reaching multi-year highs of 10%, but macro and trade war fears have kept international investors more focused on the US and Europe. However, with the yen now almost 8% weaker than its strongest levels in May, analysts are starting to factor in a surprise in corporate announcements.
According to the Wall Street Journal, Japanese management has been conservative in their near-term outlook estimating top-line sales growth to fall from 6.7% last year to 3.7% in the current FY 3/2019. Furthermore corporate $/yen assumptions of ¥105 for the fiscal year ending 2019 now look too conservative with the April 1-September 27 average registering at ¥110.6. According to Wisdom Tree Japan that difference could add approximately 5% to bottom line numbers.
Also, Japan is one of the only global equity markets to see earnings upgrades this year with analysts upping their EPS figures by 10% since the beginning of 2018. This contrasts with most of Asia that has seen downgrades. Finally, despite many years of being considered a “value trap”, fund managers think that considering some of the corporate changes in the last few years, the Nikkei at approximately 12x P/E looks attractive relative to its last 12 years at 13.9x, and compared to other global indices.
Another issue that has worried foreign investors is the political fate of Prime Minister Shinzo Abe. Over the last two years, he and his Cabinet has been plagued by a variety of scandals that saw his approval rating drop to historic lows and lead to the fear that he would lose his LDP leadership position this year, thus, ending his tenure. However, despite his troubles, and intense attacks from opposition parties, his own party and the media, in September, he saw his approval jump above 40% and was easily re-elected as this head of the LDP. This will ensure another three years for Mr. Abe, the continuation of his economic program and a push to change the Japanese constitution.
Another area of optimism is some progress with the US on bi-lateral trade talks. This has been an overhang on the market with almost 60% of Nikkei constituents having some earnings component from overseas. Last week, President Trump and Mr. Abe laid the groundwork for negotiations toward a United States-Japan Trade Agreement with Mr. Trump excluding Japan from any future auto tariffs. The two parties will decide points of discussion this year and are expected to formally begin negotiations in early 2019.
The Japanese equity market has been a surprise outperformer this year and with expectations of better earnings, political continuity and the prospects of a trade deal with the US next year, investors are finding value in the market and are increasing weightings, albeit from low levels. The VFTP Thematic Portfolio holds select Japanese companies with exposure to the technology sector.