Japanese equities have dropped 10 percent from their January peak amid a selloff over the past few months.
Investors, especially international ones, are worried that the public fallout over the ongoing land-sale scandal will doom Prime Minister Shinzo Abe’s chances of re-election at the Liberal Democratic Party vote in September. Without Abe in power, “Abenomics” will likely be cast to the wayside.
Not helping matters was a deterioration in corporate sentiment in the Bank of Japan’s March Tankan survey, the first negative reading in over eight quarters. Large manufacturers’ US dollar/yen assumptions for their fiscal year 2018 business plans averaged 109.66 in the survey, suggesting reduced capital expenditures and wages if the current exchange-rate range persists.
Further weighing on investors’ minds and wallets are concerns that simmering US-China trade tensions will boil over.
These fears, while understandable, should not dissuade investors from potentially benefiting from Japan’s solid fundamentals. Corporate earnings are rising, the global economy is robust and inflation, as well as favorable trends like the labor shortage, is accelerating.
In fact, we believe the stock market will rebound over the next few months for three reasons.
First, international selling pressure, the prime culprit of the months-long equity market decline, is easing. After pulling 6.7 trillion yen (about US$63 billion) from the market in the first quarter, international investors most likely have completed their portfolio adjustments and should soon start buying back their sold positions. Also, given that the market swing has been fueled by political events, not fundamentals, we expect sentiment to ultimately improve as the political risks subside.
Second, while a stronger Japanese yen against the US dollar is a major concern for investors, USD/JPY seems to have bottomed for now at 105–106. Although we see a stronger yen against the dollar in 12 months, recent currency futures contract data shows short yen positions have been closed on the back of global risk-off sentiment.
Third, we anticipate the prevailing political issues eventually dissipating. In particular, we think Abe will survive the scandal and win re-election. Recent opinion polls showed support for his administration have dropped by 10–13 percentage points, but the latest survey indicates a 4 percentage point rebound. We see only a 5–10 percent probability of the prime minister resigning in the near future, as the Japanese public still appreciates his administration’s economic performance.
Regarding the trade tensions, our base case is for the United States and China to reach an agreement after a few more rounds of bickering and retaliatory measures. Both sides are likely aware of the consequences of engaging in an all-out trade war – reduced export and GDP growth – and neither wants to damage its economy.
Japanese equities are trading below 14 times 12-month forward EPS, even based on our conservative earnings forecasts. The market is one of the few whose P/E ratio is below its 10-year average. These valuations are attractive, in our view, especially considering the underlying reasons for their subpar levels. We remain neutral on Japanese stocks in our global asset allocation, but we believe the recent sell-off offers investors a short-term buying opportunity.
Nonetheless, the risks remain high and may escalate in the coming months. So we advise investors to focus on industries that benefit from the growing labor shortage (select consumer discretionary and technology stocks) and rising inflation (financials).
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