Benign conditions to continue while weak yen supportive of Japan earnings season
With geopolitical tensions in the Middle East having eased somewhat and Phase One of US/China trade deal finally signed, it is difficult to see what will derail the growing optimism about the global economic recovery. Inflationary trends also remain fairly tame for now, leaving the low interest rates environment intact, keeping stock markets on their liquidity-driven upward path. With the US congressional efforts to impeach President Trump also most likely to fail in the US Senate, we can’t see any likelihood of a US political turmoil that could dent confidence in the current quarter.
This relatively benign investment environment is nicely reflected on the yen/dollar rate which as we have argued has become one of the best measures of market risk perception. Having finally broken above the 110 level, the exchange rate looks poised to test its 110.50 resistance in the near term and ultimately head towards the crucial 111 level where it gapped down from last May when US/China trade talks broke down.
Needless to add, yen’s recent weakness should prove very supportive for Japanese stocks, especially as we enter the earnings season as most firms have based their projections based on Y$ exchange rate of between 105 to 108 level. We think this season’s results will also most likely to further underline the gradual recovery trend in orders both for technology sector and capital goods, the two main engines of earnings recovery in Japan which we have been very positive on from the start of 2019.
Lagging Japan’s stock market look poised for strong gains
As the US stock markets march on to new highs, Japan’s Topix has become a notable laggard again having been stuck below the 1750 level since middle of December, declining by half a percentage point since its peak on the 17th of last month while S&P has gained by nearly 4.5% and Germany’s Dax which we look closely at given its equally cyclical nature, up by 1.8%. Moreover, since the start of 2019 when markets began to bounce, S&P has gained by over 40% while Topix has rallied by only 23%, notably under-performing even Dax which has bounced by over 30% since then.
Thus, the average forward PE ratio of Japan’s broader market is just above 15x with S&P and DAX now well above 20x. Average price to book paint a similar picture of Japan looking notably cheaper with PBR for Topix at 1.2x versus S&P at 3.7x and Dax at 1.7x book. We believe this disparity in performance and valuations of Japanese stocks look unsustainable, especially given the current positive trends of weakening yen, Japan’s rising long term rates above zero and gradual steepening of the yield curve, not to mention, fast improving corporate governance structure that is leading to much activity in M&A and divestments as well increasing share buy backs and dividend hikes.
All these factors lead us to believe that Japan is by far the most attractive DM currently and we expect global institutional investors to notably raise their weighting in Japan’s stock market this year. Indeed, with Chinese economy showing strong signs of bottoming out, we view Japanese firms to be among the strongest beneficiaries given that China remains Japan’s largest trading partner by far.