30 September 2018

Japan's stock market took much of the big events of last week in its stride with Fed raising rates, BOJ continuing with its tapering of long dated bond purchases while US clearly spelt out its intention to go on a deeper trade war path with China. However, we also saw a softening of American stance towards reaching bilateral trade agreements with its traditional allies, South Korea and Japan and there are talks that US will make a compromise with Canada on concerns about its dairy market to keep Nafta rules more or less unchanged. This is a great relief for Japan's auto firms, particularly Toyota (7203) which has big production bases in Canada. 

What has also become supportive is the Japanese currency which continued to weaken, hitting its 9 month low as rising US long term rates above 3% seems to have triggered big buying of US treasuries among yield hungry Japanese institutions. With stocks supported by the weak yen and improving outlook on Japan avoiding the much feared US trade tariffs, we have turned more positive as we now believe stocks look poised to break higher. This is a big change in our mindset, having been very cautious for much of this year. 

This change in market sentiment is also supported by the technical indicators with Nikkei 225 breaking above its Y14K resistance and testing its 1991 highs. Japan's broader market represented by the Topix index has still some work to do to reach its Jan 18 highs but with financials starting to out-perform we think a breakout by the index also looks likely. Given that the ¥$ rate dictates the stock market direction in Japan, we think its recent breakout above its 200 week moving average looks very encouraging.

This change in market's outlook does not alter our strategy of remaining negative on technology and automation stocks for now as we still see more weakness in capex coming, particularly from semiconductors and flat panel markets. Moreover, we suspect the US trade spat with China is likely to get worse before potentially improving and many automation plans are likely being delayed within Chinese factories. 

However, given the speed of which so many analysts are turning negative, especially on semiconductor names, many of which we have recommended shorting this year, we do believe that slower demand is gradually being digested and perhaps we are reaching valuation levels where much of the weakness in activity over the next few quarters are being priced in. Moreover, these firms are generally exporters and exporters tend to outperform sooner or later if the yen is weak. 

We shall see but we will now be closely looking at these segments for signs of bottoming and will be shifting our short sell focus more towards names which have outperformed strongly but look highly over-valued while not being seen as yen sensitive. Two such names that are already in our short sell list are Kikkoman (2801) or Cyberagent (4751). 

With Japan stocks looking notably undervalued relative to other developed markets, with most firms having solid balance sheets, strong environmental credentials and plenty of scope to raise payouts by hiking dividends or buying back shares, the longer term picture of Japanese stocks has not changed and remain supportive of buying our market. However, as Japan is a very cyclical market by nature, we have been cautious since this publication began earlier this year.

We are finally seeing more positive market conditions ahead with financials remaining our top sector pick as BOJ is forced to taper more notably going into the last quarter of 2018. However, we believe industrials are also likely to outperform the market. What will be challenging as always if Japan's bull run resumes is finding short sell picks which we remain very focused on whichever direction the market goes.