Japanese stocks look promising as overseas investors now underweight

Tug of war between bulls and bears continues
Risk off, risk on and the cycle of daily presidential tweets continue to keep markets on their toes. With another round of US imposed tariffs on Chinese imports coming to effect on 1st of September, investors are either cautiously optimistic that both sides will eventually come to their senses or cautiously negative, fearing a retaliation from China and its impact on global economic activity but also wary that a wall of money is looking for an investment home.

US stocks which lead those in Japan still remain well supported
Plunging government bond yields, rising value of gold and falling oil price all seem to support a weaker economic outlook. However, the US stock market which continues to lead the direction of our market in Japan is holding its own with SPX trading just 3% below its all-time highs as search for high yielding stocks and optimism about secular growth in technology has kept the market from correcting much for now.

Overseas investors now underweight Japan, leaving us more optimistic
Nevertheless, Japan’s Topix index remains 20% below its January 2018 highs as our market is not only one of the most cyclically sensitive DMs, not unlike that of Germany, though highly sensitive to economic activity in China, Japan’s largest trading partner. With exogenous shocks of the past year leading overseas investors to underweight Japan we are slowly turning more positive or at least less negative on our market as domestic investors look to be stepping in by turning net buyers.

Not out of the woods yet as stronger yen provides more headwind
With earnings multiple of Japan’s broader market averaging 12x, earnings yields are starting to look increasingly attractive versus US stocks, especially in light of negative rates offered by JGBs. However, we are not out of the woods yet as the spectre of stronger yen looms large over Japan corporate earnings for this term and notable downward revisions in full term projections look all but certain in the next earnings season.

BOJ board members sounding more cautious of lowering rates
This brings us back to Japan’s central bank which we continue to strongly believe has no bullets left to ease monetary policy from here. Indeed, some BOJ board members have expressed their caution in allowing long term rates to fall any further which would put more negative pressure on banks, insurers, pension funds and savers. As we have long argued with close to 40% of Corporate Japan being literally debt free, it is arguable how further monetary easing could help reflate the economy which has been negatively impacted by slowing global capex.

Latest QE operations point to further cuts in long dated JGB purchases
With BOJ further cutting its long-dated JGB purchases in August, the central bank is clearly trying to stave off a big yield-curve inversion, a strategy which we feel it should have adopted much earlier by eliminating its inflation targeting. After all, if lending margins get crushed by lower rates, banks will be less inclined to lend, something that the BOJ governor seems not to have grasped or refused to acknowledge.

Disparity in wealth distribution a destabilising factor as shown in the US
As we have also argued, with fast ageing Japan’s demographics and low birth rates, BOJ’s attempts in creating higher rate of inflationary expectations through pushing up asset prices is doomed to fail and could lead to a major disparity in wealth distribution. In the US this has led to political upheaval and much soul searching of late by Corporate America, to care not only for its shareholders but also more about its employees and customers. Suddenly, Corporate Japan which has long prioritised the latter two over shareholders does not seem to be such a basket case.

Our investment playbook
Finally, we want to address our investment playbook for the rest of this year without going into details in regard to stock selection in this note. With spending among data centres looking to be bottoming out before year-end, we have become more positive about the prospects of semiconductor names but very selectively as Japan/South Korean spat has raised further uncertainties in that segment of the market. With data generation continuing to grow exponentially, we feel it is only a matter of time before capital outlays return to growth phase again. We also believe that demand for factory automation will rebound strongly as export bases catering for the US market are forced to relocate out of China with the most automated lines likely to be moved out first. Lastly, we are also turning more positive about the shares of Japan’s largest lenders as fear of further loosening of monetary policy start to dissipate, leaving banks stocks at highly attractive levels.