Japan stocks back in vogue while we continue to prefer domestic plays

Following the last two weeks of client visits in Asia, we came away somewhat surprised about how quickly sentiment has turned very positive on Japanese stocks. To be sure, China’s disappointingly uneven economic recovery following the lifting of its Covid restrictions, coupled with fears of geopolitical risks in investing in the region seem to have partly helped our market. 

With yen remaining weak, helping earnings outlook of the multinationals, banks looking fairly insulated from duration risk issues, firms broadly increasing shareholders returns and with inbound tourism booming, there are good reasons to expect rising asset allocation to Japan’s stock market to continue in the near term. This is especially the case as overseas investors remain underweight Japan despite the net inflows which we have seen in the past 6 weeks. 

Moreover, with Japanese car makers’ output recovering fast as related chip shortages are disappearing, its near-term positive impact across the industry cannot be underestimated. We think we should see auto output normalising by the end of summer and related material, components and parts suppliers across many sectors could see a significant earnings upside in the second half of this year. 

Having said that, we also continue to believe inflationary pressures are rising in Japan and BOJ’s outlook for CPI to fall below 2% later this year looks wildly off the mark. Certainly, our regular corporate contacts suggest that rising costs are being passed down the supply chain, albeit at a more gradual pace as Japanese firms tend to have much longer-term supply agreements with their customers.

Indeed, the latest Japan core inflation gauge for April which excludes fresh foods and energy and one which is not impacted by government’s big household subsidies rose by just over 4% YoY. This represented the biggest leap since 1981. With Japan’s structural labour shortage likely to keep up wage pressure in the medium-term, we also see service prices remaining on an upward trend for the foreseeable future . 

Considering recent regulatory approval for electric power firms to raise their tariffs by as much as 40% while railway fares are also on the rise, we can’t see how inflation rate in Japan could ease anytime soon. Indeed, should the government discontinue or cut its generous household subsidies which is due to end in September, even headline inflation rate which peaked in January is likely to spike up again despite recent declines in oil and gas prices. 

This leaves us expecting BOJ to dramatically tweak its yield curve control operations in summer, by finally allowing longer term rates to trend higher. However, we also think that the potential upside in JGB yields will remain fairly limited as domestic institutional investors are waiting on the wings to raise their exposure if the ten-year benchmark rate is allowed to move freely above the bank’s current 0.5% ceiling and towards say 1% level. Given the above scenario, we stick with our stronger yen outlook for this year. 

Moreover, considering the recent boom in inbound tourism in Japan, rising net capital inflows into stocks, and high currency hedging costs which leave investments into US treasuries somewhat unattractive, we suspect the recent yen’s weakness has been mainly driven by short-term yen carry trades which could quickly reverse as they did last October. This outlook is also supported by growing disinflationary trends in the US economy which should lead to narrower interest rate differentials in favour of the Japanese currency. 

This we think leaves market sectors with potential to notably diverge in terms of relative performance. So, although we remain generally positive on domestic related stocks, particularly financial names, deep value cyclicals and inbound tourism plays, we think shares of exporters and multinationals which have seen their bottom-line being flattered by the weak yen look vulnerable. Moreover, this view is also supported by ongoing credit contraction in the US, not to mention, weakish end-demand in China.