Generational monetary regime change while Japan stocks shine
As we have explained, March could prove a pivotal month for 2021 as rising rates have strongly signalled what could be a generational change in the US monetary regime. This is not only raising questions about the relevance of the old 60/40 rule of asset allocation, after forty years of its spectacular performance, but it also has dramatically altered the list of stock market leaders, away from secular growth and into cyclical value names.
Another interesting development is the significant outperformance of Japanese stocks relative to other DMs this quarter, underlining the importance of Japan exposure at this stage. The Topix just managed to clear our quarter-end target and its key psychological resistance line of ¥2,000, taking us back to 1991 when it was trading there, and the start of what would prove to be, at least in our perspective, market’s two decades of irrelevance.
More reasons to raise Japan exposure
Those days are gone, and we think the global rally in cyclical stocks bodes well for our market which is not only one of the most economic sensitive among the majors, but it is the world’s second largest in size. Also, Japan still trades at very modest valuations and corporate balance sheets are fairly solid coming out of the pandemic. With US relations with China looking still strained, we think Japan equity exposure also provides good gearing to China’s economic activity without the geopolitical risks, not to mention, balance sheet pitfalls that direct investments in China could currently entail.
Moreover, with rising US rates having pushed up the ¥$ rate towards that key 109 level which if cleared, it technically leaves the exchange rate with far more short-term upside, possibly to as high as 112, we are seeing a major formation of an earnings tailwind for Japan exporters which we had not previously anticipated for this year. With improving corporate governance and big share buybacks/retirements continuing, we see another big rerating coming that could take Topix to ¥2400 by summer.
Nikkei/Topix (NT) ratio reversing course after 15 years
Although the NT ratio might not be a familiar measure, to us Japan specialists, Nikkei’s massive 15-year outperformance relative to the broader market partly symbolises the pain endured during Japan’s two lost decades of soul searching. We thus think, one of our biggest calls going into 2021 has been that we think the Nikkei 225’s historic run relative to TOPIX is coming to an end.
News that BOJ will no longer acquire domestic equity ETFs at regular intervals and when it does, it will not buy Nikkei 225-related but those of Topix came as a major jolt to investors last Friday. With the Topix Index also being revamped with one aim being to raise the free float ratio of the first section stocks, this is pushing listed companies to aggressively retire their treasury shares and by doing so, also elevating their earnings per share. With more than a quarter of stocks listed in the first section index having less than 50% free float and likely need to raise that or potentially face being demoted to second section, this may prove to be yet another good reason to bet on NT ratio to fall.
We have argued that long Topix, short NK225 is a very elegant and highly correlated pair trade that nicely captures the current market mood. Shorting Nikkei provides good downside protection against potential selling in high priced growth names continuing. Meanwhile, the rerating in cyclicals which are better represented in the broader index should also help Topix gain more lost ground. From its peak at 15.6x at the end of February the NT ratio has already dropped by over 5.5%, a huge move considering the high correlation of the two Japanese stock market indices. We see at least another 20% downside for this year.