Japan fertile ground for L/S funds while K-shaped markets fade in memory

Tech derating should continue, pushing down PEs to low teens
With the Fed looking fairly comfortable for now to allow market forces to dictate long term rates, we don’t think this rate normalisation tantrum is close to its conclusion. Indeed, news from the Covid front is turning increasingly positive as an end to the pandemic is within sight. Meanwhile, rising input costs and improving global economic activity, have all laid the foundation for a further climb in rates. In fact, we would not be surprised to see the US ten-year yield nearing its pre-pandemic level of 2% sometime soon. 

As we underlined last week, the prevailing wisdom seems to equate rising rates to a sell signal for growth stocks, leaving even the most solid bottom-up picks in this space likely to struggle for alpha until this huge macro headwind subsides. We think earnings multiples of growth names could fall much lower from here, as bottom-line projections remain on an uptrend while investors are forced to cut exposure in favour of normalisation trades. 

This scenario could squeeze PEs from both sides and in many cases create value traps in the short term which investors should be wary of. We think earnings multiples could fall to low teens in the case of Japan tech names, especially as recent capacity shortages have muddied visibility and have led to some concerns about potential double-ordering and a false market. Moreover, with economic re-openings likely to remove some of the positive earnings distortion of the past year’s lockdowns, questions about how much normalisation could prove a drag on earnings of pandemic beneficiaries in the technology space could linger on for a while. 

Japan looking well placed for a notable out-performance 
We think how equity funds are positioned this month could prove pivotal for their 2021 performance as the pandemic-fuelled K-shaped markets of last year become distant memory. For long/short funds, we feel that this current two-way market is creating huge shorting opportunities that one dared not risk last year given the exuberance at the time. Meanwhile, deeper cyclicals which are currently associated with value along with travel and leisure-related names continue to outperform nicely, adding more pressure on funds that are tech/growth heavy to make some hard decisions. 

As far as Japan equities are concerned, not only it is one of the deepest markets to borrow shares for shorting and hedging risks, but as one of the most cyclical markets among the majors, we think outperformance of economic sensitive names bodes generally very well for Japan. Moreover, Japanese equities have also become an increasingly safer bet on China’s economic recovery as the growing rift between China and the West have proved increasingly disruptive to direct investments. Given that China remains Japan’s largest trading partner by far, Japanese stocks provide ample exposure to the region’s recovery and growth with less geopolitical and balance sheet risks. 

Furthermore, with higher US rates greatly improving the forex scenario of Japan’s exporters as the yen has depreciated further against the dollar, this sudden earnings tailwind could not have come at a better time as Japanese export volumes are on a solid recovery path. For overseas investors of course, it seems it is time to hedge up the yen exposure in case the unit weakened much from here. We are also hearing that the yen-carry trade is making a big come back which suggests that the Japanese currency could weaken further by speculative forces and that in turn, should help further improve exporters’ earnings.