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So far, 2014 has been the year of the falling stocks in Japan. Japanese equities have lagged global stocks; their year-to-date performance is on par with stocks in crisis-plagued Russia.

As Japan’s economic growth momentum has slowed, structural reforms have generally been moving at a snail’s pace and the Bank of Japan (BOJ) hasn’t taken any further easing action, Japanese bulls have been growing impatient. Quick institutional money has been leaving the country in recent months, and the Japanese stock market is no longer the most crowded trade in the world, as it was last year.

It’s hardly surprising, then, that many investors are now wondering whether I’m still bullish on the land of the rising sun. The short answer: Yes. In my opinion, Japan still stands out as one of the best bargains in the developed world. Consider these five factors supporting the case for Japanese stocks for the remainder of the year.

Today’s global economic environment. In the second half of 2014, I expect the global economic recovery to continue and U.S. interest rates to moderately rise. Historically, an improving global economy and rebounding Treasury yields coincide with strength in Japanese stocks.

Stabilizing growth in China. Japan’s key trading partner is showing signs of stabilizing growth, which should help improve investor sentiment toward Asian markets as well as boost Japanese exports.

Growth initiatives are set to regain momentum this summer. While key reforms meant to spur long-term growth stalled earlier this year, Prime Minister Abe’s revamped growth initiatives due in late June could generate new investor enthusiasm. Meanwhile, a proposed cut in corporate taxes (to 20% from around 35%) could be a major positive surprise for the equity market if implemented at a quicker-than-expected pace. In addition, improving corporate governance and a shift toward equity allocation by the giant Government Pension Investment Fund (GPIF) could also reignite inflows.

The earnings outlook for Japanese firms. While the U.S. corporate sector has experienced little or even negative earnings growth in recent fiscal years, Japanese firms have posted solid earnings growth and it’s worth noting that Japanese accounting standards are more conservative than elsewhere. Looking forward, I believe there is room for upward revision to currently low Japanese earnings estimates, given that current (and as always, conservative) projections were created at the start of the calendar year. Back then, the global growth outlook was less certain, and corporate guidance was more timid than usual due to now-resolved uncertainty over spring wage negotiations and a consumption tax hike. These upward revisions could provide a boost to Japanese stocks in coming months, especially if a corporate tax cut is passed over the summer.

A weaker yen. The continued U.S. recovery and the divergent U.S. and Japanese monetary policies imply a weaker yen (vs. the dollar) in the medium term. This, in turn, should help support Japanese corporate earnings.

To be sure, the Japanese stock market is not without its risks. In the near term, many investors are expecting the BOJ to come to the rescue with additional monetary easing this summer given that inflation remains well below the central bank’s target. So, there’s the risk that the BOJ will maintain its current policy for longer than the market expects.

Even more importantly, over the longer term, the case for Japanese equities rests on structural reforms and improving corporate governance, changes that will take time. Still, given the many factors supporting Japanese equities, and especially a hedged position in the market, in 2014, I think Japan is an attractive bargain worth considering. In fact, other investors appear to be realizing this too. While Japanese stocks are certainly still down year-to-date, they are currently roughly 9% up from their April lows.

 

Sources: BlackRock, Bloomberg

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.

 

International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/ developing markets or in concentrations of single countries.

 

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