18 March 2018

We start our first weekly piece by underlining some of our basic thoughts on the Japanese market both for short and longer term. We think political uncertainties both at home and abroad could continue to weigh on Japanese stocks despite good buying support by domestic investors, particularly the retail as well as the usual monthly BOJ ETF purchases. Nevertheless, we feel politics could prove critical to market moves should support for Japan's LDP ruling party start to dwindle again as most recent polls seem to suggest.

With the North Korean situation having calmed for now, one key reason behind the resurgence of Shinzo Abe's popularity has subsided with it. With MOF admitting that it had actually doctored official documents to sell land more cheaply to a school operator connected with the PM’s wife, we suspect that the Finance Minister, Aso-san will have to step down, mainly to deflect heat from Abe and the ruling party, leaving very little chance for constitutional reform that remains the cornerstone of Abe's rightwing policies. Any threat to LDP's rule will endanger the nuclear restarts, not to mention, benefeciaries of LDP’s pork barrel politics, namely Japan's bloated construction industry. 

 

Glimpsing outside briefly, we believe the sacking of the US Secretary of State, Rex Tillerson although hardly shocking, it strongly raises the possibility of the Trump administration finally walk away from the Iran nuclear deal, and potentially exert more pressure on Qatar to comply with demands of other leading Gulf States. Needless to add, any further instability in the Middle East could exert upward pressure on energy prices, not to mention, dampen sentiment that could invariably lead to a stronger Japanese currency, a risk-off trade by default. 

To be sure, the Japanese equity market had started showing encouraging signs of decoupling from yen's moves last year. However, we doubt that the market will remain as well behaved in the shorter term if indeed the yen tests and breaks below parity against the Greenback. With that key Y106 level being severely tested, any further dips below that support line could easily take the Y$ rate back to 100, possibly a little stronger. We also suspect the structural forces in play namely the flooding of short term paper by the US Treasury, and the combination of gradual de-dollarisation of trade, expanding US Budget deficit following the most recent tax reforms, rising US trade barriers and China’s emergence as an open trade champion are all helping to add more selling pressure on the US dollar. 

By trade, we are bottom-up stock pickers but we think the geopolitical risks above cannot be ignored for now despite Japanese stocks' solid fundamentals and very attractive valuations. Indeed we would view any sell-off related to adverse forex moves as a strong buying opportunity as Japan is not only one of the more cheaper equity markets but also one of the most liquid. Add the big restructuring potential for some of the more operationally leveraged industrials, and generally rising returns to shareholders through dividends and buy-backs, Japan's stock market looks very well positioned in the medium term. 

But for now we remain cautious and have been more vocal about shorting some of our key picks that have run strongly over the past 18 months and generally look to be facing capacity constraints that either limit their growth potential going forward, or forcing them to boost capex which should raise depreciation costs, just when growth cycles could begin to cool off. 

Although on one hand China is fast shutting down its environmentally polluting factories in areas like coal, steels, cement, PVC etc., greatly benefiting some of Japan's upstream plays, it is also building huge government-funded capacities in technology fields which we believe could lead to some major overcapacity issues over the next 18 months. One strong example for this is the LCD market which we think should see capex collapse by next year after more than 5 years of strong expansion is leading to a major over-supply situation. We think the semiconductor market which appears in far better shape could also come under pricing pressure, especially as smartphone markets mature and memory content growth start to slow.

 
Nevertheless, we remain very excited about the medium-term growth potential of some key segments of the market where Japanese firms have strong leading positions. These areas include solid state batteries, automotive-related sensors, passive and semiconductors, not to mention, robotics, electric motors and other high precision parts. 

 

We are equally keen on disruptions that these trends could bring with them, particularly in the automotive segment which looks as vulnerable as Japan's electronics industry did 20 years ago before digitalisation decimated margins. Indeed, the market looks fairly exciting in both picking longs and shorts and we expect stock picking going forward to play a much crucial role in capturing alpha going forward. 

 

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