Our top-down views and why we remain bullish Japan
Our near-term top-down outlook is simply that as long as US long bond yields trend higher, Japan as one of the most cyclical stock markets should outperform others. This comes despite the recent sell-off which has been partly triggered by the ruling LDP’s leadership choice, dashing hopes for more reforms and raising prospects for higher investment taxes. But all in all, we think the market should rebound as we pass the Lower House elections next month.
We also believe input costs in Japan will prove to be far less problematic given the long-term supply agreements of Corporate Japan which should leave profit margins less scathed. We have been also sceptical that rising inflationary pressures are transitory enough that could justify US long bond yields near their record pandemic-lows. With Covid mortality rates under control and promising new treatments on their way, and as we learn to live with the pathogen, we have hopes for more evenly spread economic recovery ahead for next year that leave Japan’s cyclical/value names as well as travel-related plays looking very attractive here.
We see US rates rising further but stagflation looking unlikely
Looking at supply chain disruptions caused by the spread of the delta variant and series of reportedly climate-related disasters, it has been fairly obvious since summer that stress on the supply chains will intensify, pushing out any prospects for normalisation until after the year-end demand rush.
For the medium-term, we see that the pandemic has had a profound impact on how we want to live our lives. This fascinating change in mindset seems to be causing notable labour shortages, particularly in the service sectors of US and Western economies. One more bigger picture issue with inflation is that if indeed, we are going to enter another cold war which will theoretically force de-globalisation, world’s supply chains could fracture permanently adding more upward pressure on prices over the medium term.
So, although we agree that some of the inflationary pressures related to logistics bottlenecks and recent supply chain disruptions will undoubtedly ease by year-end, some should prove far stickier. However, we are also convinced that the Fed is unlikely to choke the economy by tightening too fast, knowing that tighter monetary policy will not necessarily help ease these structural inflationary forces in play. This is why we are highly sceptical of stagflationary scenarios, particularly given the robust balance sheets of corporates and households.
Capital goods and semis remain fertile grounds for short sell picks
Nevertheless, we have been actively looking for more short ideas as we see scope for disappointing forward earnings guidance in the near term. With weaker end-demand in both US and China starting to impact order growth, we suspect we are nearing a peak in earnings in some key market segments where valuations look stretched. With front-loading of capex budgets in China also looking to have passed its peak, we see Japan’s top factory automation plays as one segment that is particularly vulnerable in the near term.
We also retain our negative stance on semiconductor-related names given their high earnings expectations that could disappoint. We see falling output of end-products effected by ongoing supply-side disruptions and more notable demand exhaustion of stay-at-home, work-from-home regimes, all leaving the sector vulnerable ahead of the coming earnings season. We also think these crosscurrents could expose the over-bookings of chips and other key components that we suspect have created a false market and could lead to oversupply issues and cancellations over the next few quarters.
Geopolitical considerations have also added a layer of complexity to potential medium-term risks in tech names. Although exports of cutting-edge technologies to China have already been blocked during Trump’s presidency, we think the growing likelihood for a more broader export restrictions to the country could effectively wipe away a big chunk of order books of equipment and materials suppliers. Interestingly, recent attempts by the US Bureau of Industry to gather more information to better understand the supply chain issues in the semiconductor sector have been viewed with suspicion with TSMC refusing to unveil the list of its top customers which will include many Chinese firms that US might not like.