Secular rerating of Japan stocks continues despite weaker overseas activity

Net capital inflows into Japan’s equity market are continuing and with yen remaining weak, there is near term earnings support for multinationals listed in the Nikkei 225 index which global funds typically buy when they go after Japan. Add the recent interest in the AI theme which has also proved very supportive for Japan semiconductor related names and you can see why we have had a potent mix of forces in play that have helped our market reach its three-decade highs.
We also suspect a good part of these global inflows are by default as capital is leaving China and is looking for a liquid home. This could slow or even reverse if and when China’s economic activity improves and Chinese equity investors go home. But in the near term, global appetite for Japanese equities remains strong, bringing challenging times to generate alpha and in keeping up with the inflows into big Nikkei stocks. 

To be sure, there are the usual good reasons to be invested in Japan. At 14x average forward earnings and 1.3x book, the broader market remains attractively valued. Moreover, after decades of soul-searching, corporations have been improving capital efficiencies and shareholders returns. With Japan Exchange also threatening to demote those that trade in the primary market but are valued below their book value, there are good incentives for buybacks to continue. 

In the near term, Japan’s domestic economy is also looking ok as capital investments seem to be picking up steam. Meanwhile, strong inbound traffic of tourism is continuing, providing a much-needed boost to Japan’s service sector where prices are also starting to move higher. 

We are also seeing a strong recovery in Japanese auto output as chip shortages have practically disappeared. This should provide a big earnings boost across the industry that supply car makers. This will also prove a temporary boost which will likely fade by this time next year once car makers catch up with deliveries. But for now, rebounding auto production is a big positive factor for near term earnings.

Interestingly, Japanese institutional investors have been cutting their home equity exposure into the market rally as they generally tend to when overseas interest in Japan stocks rise. However, from their perspective, the external picture does not look great for equities in general and given that they naturally have ample domestic equity exposure, they have become forced net sellers of domestic stocks. 

Besides the secular market rerating of Japan which looks likely to continue for now, we really don’t see too much to cheer about, especially as second half corporate earnings recovery assumptions are starting to look suspect. Indeed, US end-demand seems to be weakening further as we suspect credit contraction is taking its toll. Moreover, China doesn’t seem to have quite recovered from the psychological impact of its long Covid lock-downs. Then there are obvious geopolitically risks that add more layers of complexity, especially in tech. 

Another big tail risk re-emerging is the war in eastern Europe which seems to be raging again as the Ukrainian counter-offensive has reportedly begun. As we have already witnessed with blowing up of Kakhovka dam, this leaves critical infrastructure including nuclear reactors in danger of being caught in the cross-fire or worse, they could become a potential target of Russia’s scorched earth tactics.