By Atsushi Horikawa
Since the Brexit referendum and the US presidential election, Japanese equities have been coming out of a funk. We believe that the rebound is supported by fundamentals - and could have staying power.
Events taking place far from Japan had a big impact on the market this year. The surge in global investor anxiety ahead of the Brexit vote and the US presidential election took a toll on the Tokyo Stock Exchange. But Japanese equities have made a strong comeback since Donald Trump's victory in the US presidential election.
Much of the upturn can be attributed to relief about the benign reaction in global markets to the surprise outcomes of those votes. But we believe that the rise is also due to an underlying improvement in the Japanese economy that began several years ago and remains underappreciated by investors. Valuations are still unduly depressed in many companies and sectors, which offer attractive investment opportunities, in our view.
Another False Dawn?
In recent years, Abenomics was the primary catalyst for strong gains of Japanese stocks. The Abenomics rally began in late 2012, shortly before Prime Minister Shinzo Abe took office. It boosted the Nikkei Stock Average from around 9,000 to a peak just below 21,000 in mid-2015. Domestically-focused stocks in areas like real estate were the main beneficiaries, even though they were often already quite expensive relative to the rest of the Japanese market. But it started to look like another false dawn. This year, worries about negative Japanese interest rates, a hard landing in the Chinese economy and prospects of US monetary tightening cast a shadow over the market. The Bank of Japan's battle against deflation, which was at the heart of Abenomics, looked futile in the face of lower oil prices, while the yen's rebound pressured exporters. The Nikkei dropped to a trough of around 15,000 by mid-2016.
Heightened risk aversion was palpable. Investors preferred the safer, more stable low-beta stocks, over riskier high-beta stocks. Cheaper value stocks - with low valuation multiples - fell even further, too. The gap between the valuations of these types of equities reached historic proportions.
Recently, Japanese stock indices are looking much more upbeat. Global markets quickly recovered from the Brexit vote in June. Trump's victory in the US election boosted growth expectations, strengthening the US dollar and weakening the yen, brightening the outlook for exporters.
And there are signs that large distortions within the market caused by elevated anxiety are finally starting to correct. High-beta stocks reclaimed some of the lost ground, and stocks with low price/earnings outperformed (Display). The Nikkei bounced back above 18,000.
Structural Improvements Point To Sustained Recovery
The post-election rally has no doubt been helped by a renewed depreciation in the yen. But that can't be the only explanation, because the market did well after the Brexit vote, which was accompanied by a big spike in the yen. We believe that the recovery reflects the magnitude of the excess risk premium priced in the market, as well as improvements in fundamentals that are not fully priced in yet.
Structural reform is the less visible catalyst. On this front, the Japanese economy has made steady, if quiet, progress over the past several years. For instance, a gradual improvement in corporate governance, which has made corporate management more focused on shareholders' interest, has contributed to a marked increase in shareholder returns in the form of stock buybacks and dividends (Display).
Many companies have also become leaner and meaner. Our bottom-up company research suggests that some companies have increased their earnings even after stripping out the windfall effect of the yen's depreciation since 2012. For instance, semiconductor-production-equipment maker Screen Holdings (OTC:DINRY), whose profitability had been surprisingly low for a company with a dominant market position in its mainstay products, has made strides in addressing its problems. Chemical company Asahi Kasei (OTCPK:AHKSF) has shifted its business portfolio away from commoditized products to more profitable areas such as healthcare, construction and specialty chemicals. These efforts make those companies' earnings more resilient against cyclical downturns.
History suggests that the pace of the recent rally cannot be maintained for too long. But we believe that the normalization of the Japanese stock market still has ways to go, supported by structural improvements in corporate fundamentals. By searching for undervalued companies that are at the forefront of unfolding changes to Japan's corporate culture, we believe that investors can identify solid sources of returns as the market recovers from the excessive pessimism of recent years.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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