The rally in Japanese stocks in recent months is likely to continue, supported by an encouraging earnings outlook, low valuations and the ongoing ultra-easy monetary policy, we believe.
We looked at how Japanese equity performance and valuation have trended since 1990. Japanese equities are approaching peaks they have struggled to climb over in past decades, but we think this time may be different. Valuation (green line) is lower today than at previous high points in stock market performance (blue line), as the chart shows. Moreover, Japanese stocks appear inexpensive on the global stage. They are trading at a 20% discount to U.S. peers on a 12-month forward price-to-earnings basis, for example.
More than just valuations
Low valuations alone are not a reliable buy signal, yet we find an improving earnings outlook adds to the appeal of Japanese equities. We expect Japanese companies’ earnings growth to hit a three-year high in 2017. A sustained global economic expansion is boosting overseas earnings, while wages are rising just enough to bolster domestic consumption without eroding profit margins. The recovery in earnings also reflects companies’ greater focus on shareholder returns. Progress is being made on profitability, which has long dogged Japanese firms. Return on assets, a gauge of corporate efficiency, has risen back toward pre-crisis peaks. Japanese companies have also deleveraged meaningfully, yet their profitability remains well below many other developed markets. Earnings, meanwhile, are rising faster than dividend payouts and buybacks, and this provides considerable scope to improve shareholder returns.
The Bank of Japan’s (BoJ’s) equity purchases and domestic investors’ increasing preference for stocks provide further support. Our analysis shows Japanese equities remain far from a crowded trade as foreign investor flows into Japan have recently subsided. A further support is the BoJ’s ultra-easy monetary policy, which contrasts with a normalizing Federal Reserve and a looming step change in the European Central Bank’s monetary stimulus. We see this helping keep the yen in a stable trading range. A sharp rise in the yen is the main risk to the Japanese equity rally.
Bottom line: We remain overweight Japanese equities (currency-hedged in the case of non-Japanese investors), and prefer stocks with greater foreign earnings growth. Read more market insights in my Weekly Commentary.