By Ashley Kindergan
What's next for Japanese corporate earnings? Well, that depends. Consider the April to June Japanese earnings season, which can be considered a pleasant surprise or a bleak portend based on which numbers you choose to accentuate. Where you stand on Japan depends on where you sit. The quarter was a winner in terms of performance relative to past expectations.
Japanese companies beat consensus estimates for both operating and net profits by 11 percent, and twice as many companies beat consensus estimates by at least 10 percent as missed by the same margin. Future expectations, on the other hand, look gloomy. Japanese companies reduced their full-year operating and net profit outlooks by 1.5 percent - and twice as many companies cut operating profit guidance as raised it.
Even more troubling, most of the companies that lowered their guidance did so based on assumptions that the yen would trade at ¥105 to the dollar over the course of the year. As of late-August, however, it was trading at ¥103 to the dollar, raising the prospect that export-oriented companies perform worse than expected. Over the last three years, Japanese firms led the world in the proportion of analysts revising their earnings estimates higher.
More Japanese firms - 61 percent - have seen their earnings expectations reduced over the last 13 weeks than in any other regional market. What's more, those downward revisions are also larger in size than in any other region, with analysts cutting expectations for cash flow return on investment by 0.25 percentage points.
Still, the Credit Suisse global equity strategy team believes that the pessimism has gone too far, with consensus expectations too dour - both in Japan and around the globe, the latter of which is clear from the unjustifiably high equity risk premium.
The Nikkei 225 has risen 9.5 percent since a July trough, but by the end of the year, Credit Suisse expects the index to rise another 7.5 percent to hit 18,000, noting that the Japanese market seems to be stabilizing after a tumultuous year.
After hitting a high of 50.24 in February, two weeks after the Bank of Japan shocked markets by announcing its negative interest rate policy, the Nikkei Stock Average Volatility Index hit its lowest point all year on August 12 at 18.45, suggesting that the stock market is more stable than it was before.
Another good sign: A rotation into cyclical stocks that began when Prime Minister Shinzo Abe's party won a majority in elections for the Upper House of the Diet in July. The stocks of financial firms, automakers, steel manufacturers, machinery companies, and technology companies have enjoyed strong rallies since the elections, indicating investor optimism about the direction of the economy.
The most immediate risk to a Japanese equities rally is that Abe uses his election mandate to push through a highly controversial change to Japanese constitution that would allow the country to take a more active military role in global security, rather than focusing on structural economic reforms. De-emphasizing economic reforms risks disappointing foreign investors and sending them to look for opportunities elsewhere.
But that political risk isn't reason enough to underweight Japanese equities, and the global equity strategists maintain a neutral weighting on Japanese stocks within an international stock portfolio. And a number of metrics appear quite supportive of that view. Foreigners are selling Japanese stocks in droves, and as a result, they're much cheaper than U.S. stocks on a 12-month forward price-to-earnings basis.
Despite the recent rally in financial stocks, Japanese banks remain particularly oversold, with the cost of equity at an all-time high relative to European banks. Trends in share buybacks also favor Japanese stocks. Some 546 companies have announced repurchase plans worth ¥5.2 trillion in 2016. If that pace continues for the rest of the year, the value of announced buybacks will surpass ¥8.5 trillion, a level not seen since 2002.
But unlike this one, that buying spree had a specific catalyst: The passage of an October 2001 law that allowed Japanese firms to re-sell their own stocks, rather than being forced to retire the shares. Today's buybacks are also much larger than in 2002, in part due to the fact that many large blue-chip firms such as Toyota, Nissan, and Fuji Heavy Industries are buying back their own shares.
The average buyback announced in 2016 has been ¥9.5 billion, compared to ¥5.2 billion in 2002. So yes, there are risks. But Japanese equities are also cheap, increasingly stable, and have a structural growth driver in the form of rising stock repurchases. Let the recovery continue.