Does Japan’s sell-off present buying opportunities?

Daisuke Nomoto, Senior Portfolio Manager | February 10, 2014

  • What’s behind the Japanese stock market’s recent correction?
  • What’s ahead for Japan’s stock market, currency and government policy?
  • Why the risk/reward tradeoff looks attractive at current price levels

Abenomics has already had a bigger impact on the Japanese economy and financial assets than the failed attempt at quantitative easing between 2001 and 2006 (see chart). Inflation has moved back into positive territory, and household income is rising (we expect a roughly 2% wage hike next fiscal year). The underlying trend in economic activity is solid today as shown in industrial production data, the Tankan survey and other economic indicators. Having said that, the global capital market sentiment recently took a turn for the worse on the back of a wave of concerns such as emerging market (EM) currency volatility, a default on a RMB3billion (U.S.$500 million) Chinese trust product, lingering political instability in Thailand, another $10 billion quantitative easing tapering decision, and finally, Japan’s upcoming consumption tax hike to 8% from 5%. The Japanese equity market was down almost 10% in just two weeks.

Daisuke

What should we do with Japanese equity investments given the recent correction? We would like to discuss a couple of key points to frame our view of what’s likely to happen in Japanese stocks going forward. First, we maintain our bearish view on the Japanese yen (which negatively correlates with the Japanese stock market) based on the expectation that the spread between U.S. and Japanese bond yields will continue to widen which would put upward pressure on the U.S. dollar vs. the yen. Further, the Bank of Japan (BoJ) intends to increase the monetary base by ¥60trillion to ¥70trillion annually. With the Federal Reserve slowing its pace of money expansion, we expect Japan’s monetary base to grow at a relatively higher rate. The BoJ is committed to a policy of large-scale purchase of Japanese government bonds (JGBs) and risk assets to stimulate economic growth and bring up inflation. If this policy is successful in increasing growth and inflation, it would sustain further advances in asset values by creating a situation where the nominal growth rate exceeds the long-term interest rate, which means there is an incentive for companies to invest. Second, it is an interesting time from a cyclical perspective. Not only is the short-term shipment/inventory cycle on an uptrend, but also longer-cycle private capital investment and infrastructure spending (to replace aged infrastructure plus special demand from the 2020 Tokyo Olympics) looks favorable. Lastly, we think that Abe’s third arrow of structural reform will come back into focus sometime later this year. Many investors were disappointed with the third arrow announcement last spring simply because it was vague and lacked specifics. Now that both the first and second arrow have shown positive results, we think the government will likely unveil a specific agenda for the third arrow particularly: i) corporate tax cuts; ii) granting a Special Economic Zone license to Tokyo, Osaka, Nagoya, Hokkaido and/or Okinawa; and iii) labor reform to ease working visa issuance to foreign workers for the construction and medical industries, raise female labor participation rate, etc. Since the market expectation of Abe’s growth strategy is somewhat low at the moment, any clarity about it could positively surprise the market.

It is hard to imagine that the Japanese stock market can rise another 40% in 2014. But so long as the government follows through on a clear agenda of reform, and the BoJ continues to keep the yield curve under control by providing ample liquidity to the financial system, then there is a good chance that Abe and Kuroda’s initial goal of 3% nominal gross domestic product growth with 2% inflation could be achieved. Hence, we believe Japanese equities may provide investors with reasonably high returns. We think that from the current price level, almost 15% lower than the previous high, the risk/reward trade-off looks attractive and we recommend taking the opportunity to add high quality names which have been sold off in excess of fundamental justifications.