This year has witnessed sharp reversals in a number of trades. Take the examples of Japan and emerging markets (EMs). Last fall, the U.S. dollar soared and EM equities, historically sensitive to dollar strength, sat out much of the rally. At the same time, Japanese stocks jumped 30% in local currency terms. This year, the situation has reversed. While Japan’s TOPIX index has turned in a respectable performance—10% in local terms and 15% in dollar terms—EM equities have been the standout performer: The MSCI Emerging Market Index is up over 25% year-to-date.
However, we may be setting up for yet another reversal. Today there are at least two reasons why relative performance may once again flip in favor of Japan.
The dollar has already given back all of its fall gains
EM equities typically benefit from a weak dollar, the opposite of what often happens with Japanese stocks. Thus far, 2017 has been defined by a sharp decline in the dollar. From the January peak to the September low, the U.S. Dollar Index lost approximately 12%. However, selling dollars has become a bit too popular and the greenback has started to stabilize. A stable or appreciating dollar would likely prove a modest headwind for EM equities and a tailwind for Japanese stocks.
Valuations now favor Japan
Emerging markets were relatively cheap when they bottomed late last fall. Based on the price-to-book (P/B) measure, the MSCI Emerging Market Index was trading at around a 30% discount to the MSCI World Index of developed markets. Given the outperformance of EM year-to-date, that discount has now reverted to around 25%, in line with the long-term average. In contrast, Japanese equities still appear particularly cheap (see chart below). The TOPIX trades at a 42% discount to the MSCI World Index. This discount compares favorably to the 20-year average of around 32%. And against EM stocks Japan appears even cheaper. Since 1995 Japan has typically traded at a 12% premium to EM equities (based on P/B). Today the TOPIX trades at a 23% discount to the MSCI Emerging Market Index. This represents the largest discount since the spring of 2014, a period that preceded a 50% rally in the TOPIX.
Valuation of assets vs. historic norm
Current valuation (bars) vs. year ago (dots)
There is at least one big risk to this thesis: The dollar continues to decline. This can happen in a few ways, for example, if the rest of the global economy continues to recover faster than the United States or we experience a significant growth or geopolitical shock that pushes investors into the yen. Japanese stocks could probably survive the former, but the latter would be more difficult. A risk-off event would not only prop up the yen but would arguably be accompanied by renewed concerns over global growth. Both factors would likely cause Japanese equities to underperform.
However, if you assume that the majority of the dollar’s near-term decline is over, it may be time to take some profits out of EM and return to Japan.