By Bill Witherell, Ph.D.
Over the past 12 months, as of July 6th, the Japanese equity market outperformed. The TOPIX index increased 31.1% and the NKY 225 30.5%. These figures compare with increases of 14.8% for the S&P 500, 19.35% for the STOXX Europe 600, and in Asia, 22.4% for the MSCI AC Asia Pacific ex Japan Index. Similar outperformance was registered over the past three months: TOPIX, 7.9% and NKY 225, 6.8%, versus S&P 500, 2.2%; STOXX 600, -0.1%; and MSCI AC AsiaPacific ex Japan, 4.6%. Over the past month, equity markets around the globe eased, and the Japan market was no exception. iShares MSCI Japan ETF (NYSEARCA:EWJ), by far the largest Japan ETF listed in the US, lost 3.25% between June 2nd and July 10th. Since then it has recovered by 1.5%. We did not consider this slight market pullback as a reason to reduce exposure to the Japanese market.
Japanese equities joined in the recent global market softness induced by rising interest rates, concerns that central banks will be reducing their quantitative easing, and perceived increasing geopolitical risk, including the North Korea threat and uncertainty about the future course of US actions. Japanese equities also suffered as a result of the substantial defeat of Prime Minister Abe's Liberal Democratic Party (LDP) in the Tokyo Metropolitan Assembly election, although that loss appears to have been just of local importance, not significantly affecting the strength of the LDP nationally. Also, Abe has been caught up in several scandals that have affected his popularity. Nevertheless, concerns about Abe's ability to remain in power and carry forward his economic policies appear unwarranted to us. The LDP's strong position nationally is not under any credible threat, and there is no serious contender to Abe's leadership within the LDP. Abe does need to rebuild public trust. The best course would be to redouble his efforts to further economic prosperity.
Some investors have been concerned that the Bank of Japan (BOJ) may intend to begin tightening its very-easy monetary policy of quantitative easing soon, while keeping the 10-year Japanese government bond (JGB) rate "around 0.00%," which appears to mean no higher than 0.10%. Last Friday, July 8th, after the rate moved slightly above 0.10%, the BOJ clearly demonstrated that it is not yielding in its battle to control yields on the benchmark 10-year JGB. It offered to buy an unlimited amount of JGBs and ended up by increasing its 5-year to 10-year operation from ¥450 billion to ¥500 billion. On Wednesday, July 12th, the BOJ also increased its buying operation of 3-year to 5-year JGBs by ¥30 billion. We anticipate that at the July 19th meeting of the BOJ's Monetary Policy Board, Governor Haruhiko Kuroda will announce that the current monetary policy is being maintained.
The macroeconomic outlook for Japan is positive, with real GDP growth likely to register above-potential annual advances of 1.4% both this year and in 2018. Firm external demand for Japanese exports, supported by a weak yen, continues to be the main driver of growth, supplemented by increases in business investment, consumer spending, and public works. The latest OECD Composite Leading Indicator for Japan implies stable growth momentum. Also, the Japan Economy Watchers Current Index reached its highest point in six months in June. Similarly, the Markit Nikkei Composite (manufacturing plus services) Output Index for June signaled continued solid expansion, completing its strongest quarter for three years. Business confidence is at its highest level since late 2015 according to the June Tankan Survey. Profit margins are improving, and capital expenditure plans have been revised upward. Labor conditions are expected to remain tight, but recent wage negotiations have not yet contributed to wage growth, as was hoped. Real earnings growth has been flat recently.
The Japanese government's efforts to reform corporate governance are a positive consideration for investors in Japanese equity markets. On July 3rd, the Government Pension Investment Fund (GPIF), the world's largest pension fund, announced the selection of three ESG (environmental, social, and governance) indices for Japanese equities in which it will invest, and began by investing 1 trillion yen in these indices. It expects to increase this amount over time. The GPIF actions have the objectives of improving disclosure at the company level, company dialogue with investors, and more broadly, corporate governance. The some 362 stocks included in the ESG indices will likely attract increased investor interest.
Japan equity valuations look favorable compared with the US market, while not as favorable as the Eurozone. Based on domestic capital weights, the forward price-to-earnings ratios are estimated as 15.7 for Japan, 17.9 for the US, and 13.6 for the Eurozone. Japan's dividend yield of 3.0% tops both the Eurozone's 2.3% and the US market's 2.0%. Net profit margins in Japan are lower than those in the US, which gives them more room to catch up, and they are improving. The Japanese economy does face some risks and calls for close monitoring: An increase in protectionism would hit Asia particularly hard; a significant period of "risk off" would likely result in a stronger yen that would hurt exports; continued weak wage growth would hamper consumption; and any significant slowdown in China would impact the region. However, in our view, the base-case scenario for Japan's economy and its equity market for the second half of this year and for 2018 is positive.
Sources: Ned Davis Research, Jeff Usher's Japan Insider, BCA Research, Oxford Economics, OECD, Goldman Sachs, Markit, Financial Times