Staying with Japan Equities

July 28, 2015

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The lead article in the July 20 [issue of] Barron’s was “Time to Buy Japan.” We agree that the Japan equity bull market still has legs. It is not too late to participate.

Consider first the macroeconomic story. The Japanese economic recovery continues. Growth in the first quarter at an annual rate of 2.4 percent was the fastest among the large developed economies, with consumption, investment and inventory build-up all contributing to the advance. Growth slowed somewhat in the second quarter but maintained momentum despite the slowdown in China. Some press commentaries have overstated the impact of China. That market accounts for 18.1 percent of Japan’s exports, compared to 18.8 percent for the United States and 10 percent for the European Union, markets that are not slowing. Indeed, a global economic reacceleration appears to be underway, while the slowdown in China looks more modest than many projected. Moreover, the lower exchange rate of the yen against other major currencies has improved Japan’s competitiveness and boosted exports.

The most recent Tankan survey of investment intentions is the strongest since 2006. More generally, the survey shows optimism in both the manufacturing and non-manufacturing sectors. Labor demand is strong. Consumption continues to recover after the drop last year due to the consumption tax increase. Overall the growth outlook looks positive well into 2016.

The massive quantitative easing program in which the Bank of Japan (BOJ) is engaged will continue indefinitely. Inflation is still close to zero, while inflation expectations are rather higher, with the majority anticipating inflation above 2 percent one year from now. The steep increase in inflation expectations must be encouraging to the BOJ. An increase in the QE program, now at the level of 80 trillion yen annually, still looks likely—but not perhaps until 2016. So far the effect of the program on broad money growth has been modest, as has been the effect on GDP growth through that channel. A greater boost has come from the program’s effects on the exchange rate and exports (positive) and imports (negative).

Another effect of the BOJ’s massive buying of Japan government bonds (JGBs) is important for the equity market. The BOJ now owns about 25 percent of the outstanding stock of JGBs, leading to significant portfolio reallocations on the part of financial institutions. This trend is particularly noticeable in the case of public pensions that are selling JGBs to the BOJ and buying equities. And not to be forgotten is the fact that the asset-buying program of the BOJ includes significant purchases of Japanese equity ETFs.

The earnings outlook for Japanese firms is encouraging. Consensus profit growth for the second quarter is 22.7 percent over the previous quarter, with a reacceleration of both revenue and earnings. Along with the favorable macroeconomic conditions, there is a new interest in corporate reforms in Japan that should begin to have a positive effect on shareholder returns through increased profits and cash returned to shareholders via dividends and share buybacks. Corporate balance sheets now contain very large amounts of cash.

Barron’s reports that Japanese company profits are already growing much faster, from a smaller basis, than those of US firms. There is great scope for Japanese firms to improve their profitability; and pressures from government, shareholders and competitors have increased substantially. Japan has introduced a new corporate governance code, which has the objective of strengthening shareholder rights. Pressure to increase dividend payouts led to a 58 percent increase in the number of firms raising their dividends last year, actions that appear to have been rewarded by the market.

 

The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.

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