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once bitten twice shy

But last year’s election victory by the Liberal Democratic Party (LDP) looks to have ushered in major political change – and with it, scope for the Japanese market to rally. Among those enthused by the country’s prospects is Jupiter Japan Income manager Simon Somerville, who sees the LDP’s policies as fundamentally market friendly.

“Businesses have operated in a political vacuum in Japan, especially in the past six years when as many prime ministers went through a revolving door and were unable to implement effective policies,” he says. “We now see excitement at the opportunity for change and the mandate Prime Minister Shinzo Abe has taken on – there appears to be a genuine belief that this time is different.”

Central to this is the 2% inflation target, a key part of Abe’s election campaign. “We have talked about the importance of inflation for years – and to have a bullish outlook on Japanese equities, there has to be inflation,” adds Somerville. “Japan’s persistent deflation has created a difficult environment for people running businesses as they struggled with constant price pressure and inflation is helpful for healthier corporate earnings.”

Inflation to the rescue

While the LDP’s pledge is specifically about inflation targeting, economists highlight currency weakening as a welcome corollary. Somerville says the long-term yen appreciation that has hampered Japan’s exporters is linked to high real interest rates and inflation should help towards much-needed currency depreciation.

Abe has also pledged to re-target government spending, implementing a massive ¥10trn (€80bn) fiscal stimulus and progressive tax reform. Together with the inflation target, many feel this could finally encourage Japanese consumers to spend some of their massive savings.

Among other managers, Invesco Perpetual’s Paul Chesson highlights Japan’s corporate profits have only had one down year since the credit crunch, and this was because of the earthquake and tsunami in 2011. “Japan’s post-crisis experience has not been so different from the rest of the developed world, and yet it seems to have borne the brunt of fears about another global crisis,” he says.

Based on assumptions of 2013 being no worse than 2012, with a stable-to-slightly-weaker currency, Chesson believes expectations of 20% pre-tax profit growth seem reasonable.

“The important point is that downside risks to this growth already seem factored into many shares more sensitive to the economic cycle,” he adds. “In our opinion, this does not reflect expectations of growth. If we are right, we have comfort that earnings disappointment should not have a serious impact on cyclical stock prices, as long as the trajectory of profits is improving to some degree.”

Vote of no-confidence

Capital Economics provides counter-thinking to any rise in bullish sentiment.

Chief global economist Julian Jessop questions if the Abe trade of recent weeks may have already run out of steam. “Recent sideways trading in the yen and Nikkei may simply be a pause, which would not be unusual following such rapid moves,” he notes.

“Nonetheless, we have three more fundamental concerns. Any further decline in the yen will run into diminishing returns and could actually be counter-productive for the economic recovery; some of the more radical proposals for monetary expansion already appear to have fallen by the wayside, and the global backdrop may be about to turn less favourable.”

On the yen, he says a weaker currency may be welcome for exporters but also increases the local price of imports. The upshot is that scope for further gains in the Nikkei look increasingly limited.

Structural reform

“Any future outperformance by Japanese equities will probably depend on the government delivering more on structural reforms,” he says. “This is the hard part, and the track record of the LDP in this regard is dire. The currency could still have further to fall once the new leadership team is confirmed at the Bank of Japan, but the pause supports our view that risks will be increasingly skewed towards renewed yen strength and Nikkei weakness by the second half of the year.”

Elsewhere, Standard Life Investments acknowledges tactical arguments in favour of Japanese assets, especially equities and real estate, but feels a longer-term strategic call depends on further structural reform. Andrew Milligan, head of global strategy at SLI, says: “Japan has seen many attempts to turn the economy around and historically it has been right to doubt how sustained policy initiatives will prove.

“The present occasion is not yet any different. If change is lacking, investors should look to rent Japanese equities for a short period, rather than owning them for the longer term.”

A further cautious note comes from GLG’s Stephen Harker, who warns against assuming a declining yen is set to remain chronically weak. “We hold no view on the future course of the yen, but simply believe that when prices have adjusted sufficiently, they stop adjusting,” he says. “This is the basis of our contrarian strategy in equities and we see no reason why this belief in cycles and the power of reversion to the mean should not apply to currencies also.”

Investor fatigue

Among fund buyers, sentiment has started to turn despite previous false starts and several upped their Japanese exposure last year. Aberdeen’s co-head of multi-manager Graham Duce says he became fatigued over recent years hearing from Japanese managers that the market was cheap.

“The problem is it got cheaper,” he stresses. “The turning point was last summer when we recognised certain areas of the market, like the electronics sector, had been beaten up. But while we agreed the market was cheap, we were reticent to increase our allocation as there seemed little political will for change.”

Instead, the team decided to increase the beta within its Japanese allocation by adding Harker’s GLG Japan Core Alpha, which remains heavily exposed to the electronics sector and other depressed areas. “Like Harker, we are strong believers in mean reversion and many of his stocks in export areas had moved far from average levels,” adds Duce.

“With the election last year giving us a government pledging to target inflation and weaken the yen, these companies have rallied strongly.”

Duce is currently letting his Japanese positions run, with the 10% exposure in MM Constellation the highest weighting in several years.

“While the Japanese market has been difficult to read, it is one of the best regions for finding managers that can generate alpha,” he adds. “Looking at performance over three years to end of February, the divergence between the best and worst funds is 96%.” Longer term, Duce stressed there remain serious issues with Japan’s economy, primarily worsening demographics and high debt.

PSigma CIO Tom Becket has been among the few asset allocators with an overweight in Japan over recent years and sees ongoing political change as potentially transformational for equities. “The inflation target should propel the Japanese yen from absurdly overvalued levels,” he says.

“With a focus on 2% inflation, fair value for the dollar/yen cross rate should be around ¥155. In effect, the yen should halve against the dollar from the ¥77 we saw last year and even if that were to partially happen, Japanese equities should boom.” With yen weakness stimulating exporters, Becket has made an upbeat forecast for Japanese corporate profit growth of 35%, although admits this could be wishful thinking.

“Japanese equities have been superb performers over the past three months, led by the currency-sensitive sectors, and many investors will now contemplate taking profit,” he adds.

tom@ybc.tv

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