20 May 2018

We see some interesting sectoral moves taking place in Japan's stock market leadership which could prove pivotal to outperforming Topix for the rest of this year.  Market mood seems generally more calmer as ¥$ rate has continued to trend higher, pulling convincingly above the 110 level and its 200 day moving average for the first time since January.

For now it seems that the US dollar is acting more on interest rate differentials and rising US rates than geopolitical, fiscal or trade concerns. It could be that the yen has been caught in the cross-currents of euro selling that seems to have gathered more pace since the Italian election results.

Selling of emerging market debt have also quickened, raising demand for the dollar and potentially adding some more pressure on the yen which for now is trending weaker despite some risk off days when one would expect to see the Japanese unit appreciate. Is the yen losing its safe haven characteristics? Perhaps the weaker yen signifies that the market is not too concerned with events to adopt 'a risk off' mode. It could also be that quickly diverging US interest rates from that of Japan is pushing Japanese investors back into buying US treasuries.

However, all these potential explanations for the yen's continued weakness does not mean investors should pile back into exporters. Indeed, Japanese stocks seem to be at the cross-roads of potentially big sector allocation, away for momentum stocks which in Japan have been mainly exporters of tech components and equipment makers, and into financials which should benefit from rising global rates which will add further pressure on BOJ to taper.

As we have argued, although Japan's inflation rate of less than 1% might seem tame at the moment, from our bottom-up analysis of many companies which have stated their earnings outlook, there is little doubt that input costs are starting to rise fast and with Japan's aging demographics adding to big labor shortage issues, corporations will have no choice but to pass these costs on at some stage soon.

This scenario keeps us bullish about the outlook of Japan's financial names, particularly its big banks which are mostly trading way below book and yielding close to 4% in dividends. With these banks starting to dramatically downsize their physical networks of branches and finally looking to share ATMs with other city banks, we think their scope for cost cutting also looks promising.

Going back to techs, with Applied Materials also sounding more cautious of more recent order inflows, particularly for flat panel display production equipment, we see a group of Japanese FPD capex plays and SPEs which we think look ripe for shorting aggressively here. For those interested to view our recommended long/short list as well as our fast growing list of suggested pair trades, please contact us to be added to our 3 months trial service.