Election win, bullish forecast have managers boosting their exposure
Global money managers are looking closely at opportunities in Japan, with the recent victory for Prime Minister Shinzo Abe and the Liberal Democratic Party reinforcing their bullishness on the country's equities market.
The benchmark Nikkei 225 jumped 1.19% in the week after the Oct. 22 parliamentary elections, when the LDP and its coalition parties kept a majority.
For the year-to-date through Nov. 8, the index has recorded a 22.9% gain. This compares with a 3.84% return for 2016 and the 8.03% return the Nikkei 225 achieved in 2015. All returns are in U.S. dollar terms.
"Japanese equities are finding a sweet spot and in mid-October, we upgraded our assessment to 'strongly favor' from 'favor' previously," said Maya Bhandari, portfolio manager, director, multiasset allocation at Columbia Threadneedle Investments in London. The firm's asset allocation strategies have been overweight or invested in Japanese equities since the summer of 2013 — a period Ms. Bhandari said was associated with both good performance and cheapening relative valuations on strong earnings delivery.
But now portfolio managers are finding additional factors to reinforce and boost their positions, she said.
Reasons for the attention include increased strength in bottom-up corporate earnings, evidence of ongoing corporate reform driving better shareholder returns; "firm economic expectations, with our forecasts consistently ahead of a rising consensus and pointing to growing nominal strength … and high operational leverage of Japan Inc. to synchronous global economic improvements," said Ms. Bhandari.
Enjoying the ride
Other money managers are enjoying the ride.
"We have been positive on Japan since Abenomics began (in December 2012) and topped up holdings after the recent general election," said Paul O'Connor, London-based head of multiasset at Janus Henderson Investors. "For us, the election result reinforced the strategic bull case for Japanese stocks."
A number of elements are coming together to make Japan a unique opportunity. "Japanese equities offer a blend of characteristics that is hard to find in other major markets, such as corporate reform, booming profits, an attractive policy mix, political stability and reasonable valuations. In addition, it is a market that typically performs well when bond yields rise. That could be a useful characteristic in 2018," said Mr. O'Connor.
Janus Henderson is partly hedged on the currency. He said for an unhedged U.K. investor, Japanese equities have performed broadly in line with other markets since Mr. Abe came to power. But between 2012 and mid-2015, hedging the yen "would have substantially boosted returns, as the (Bank of Japan's) policies caused significant currency weakness," said Mr. O'Connor. Since then, a decision on currency has become less clear as fluctuations in sterling due to the U.K. vote to leave the European Union have "complicated the picture." Janus Henderson runs £722.9 million ($948.8 million) in Japanese equity.
J.P. Morgan Asset Management (JPM)'s Tim Woodhouse, a vice president and portfolio manager in the global equities team in New York, said the firm has increased allocations to Japan across its global opportunities and global focus strategies, moving from being a little underweight to overweight in the past year. He said the position is not something that is "particularly outsized," but a number of factors such as improving economic momentum, GDP picking up and a tighter labor market are in play. "The election didn't change things a huge amount … we felt fairly comfortable with the policies that were ongoing, but it is never unhelpful to have increased certainty," he said. J.P. Morgan runs $8 billion in Japanese equities across its global equities portfolios and an additional $15 billion in Japan equity strategies.
New York-based John Vail, chief global strategist at Nikko Asset Management, expects non-domestic managers to "likely accelerate their Japanese equities purchases even further as they remain heavily underweight," but see that the country is geared toward the global reflationary trend, which he said is "already being manifested in this earnings season ... although they have improved dramatically in the past four years, Japan's profit margins remain lower than most of the rest of the world, so when revenues increase, net profits tend to rise at a faster rate than countries with high profit margins." Mr. Vail said that, given the reflationary global outlook, "it is dangerous to ignore this fact."
While Abenomics initially attracted foreign investors for a couple of years, they then sold heavily. "Since then they have been moderate buyers overall, but with little interest during much of 2017," said Mr. Vail.
However, after last month's election, interest started to increase sharply. Nikko has $66 billion in Japanese equity assets under management.
The impact of currency is also an important consideration, added Mr. Woodhouse. "We have all seen the charts on the impact of the yen on Japanese corporate earnings; so again, you have to be very aware of what is happening to the yen." J.P. Morgan executives hedge currency back to the benchmark and do not take bets on it. "But (there is) absolutely no denying that if you don't understand the impacts of currency when forecasting around the earnings, then we are going to perform very poorly," he said.
While Mr. Abe and his party's reforms have attracted investors to the market, price-earnings ratios remain at the historical average and the Bank of Japan looks set to keep monetary policy accommodative, there are differences to the market and its lure this time around.
The p/e ratio is around 15 times, despite the recent market rally, and given the current earnings momentum this level looks attractive, said Kazuyuki Terao, chief investment officer, Japan, at Allianz Global Investors in Tokyo. Risks for the market include a rapid interest rate hike in the U.S. and a North Korea-related threat, "but the probability that these events actually (will) happen looks low," he said.
And there's another difference. In the past five years, the equity market more than doubled, "supported by (a) recovery in corporate earnings and (the) BoJ's monetary policy. As corporate governance reforms are still underway, profitability and shareholder returns are expected to improve in the mid-term. Hereon, we expect stock selection to play a more important role in investments when corporate earnings momentum (diverges) due to competition and management quality," said Mr. Terao.
However, the positive factors and the rally that followed the election have led to some profit-taking and trimming of positions.
AllianzGI had been overweight the technology sector in Japan and, after recent strong performance, "we trimmed our exposure a little," said Mr. Terao. AllianzGI runs $16 billion in Asia-Pacific equity.
And BNP Paribas Asset Management's overweight view on a price-earnings basis has been offset by the growth outlook, resulting in a neutral position said Daniel Morris, London-based senior investment strategist. "Reasons for being overweight include valuations, at least looking at price-to-earnings or price-to-book. The multiples are below average for Japan." However, based on PE-growth measures, Japan looks less attractive.
But other factors are in Japan's favor such as "a surprising increase in margins," which are forecast to reach 6.2% by next year — a 460-basis-point increase from lows, added Mr. Morris.
"The margin gains suggest that perhaps there has been more to the economic reform part of Abenomics than foreign investors have realized." Added to that is a supportive central bank policy, of which a reversal in purchases "seems to be a fairly distant prospect today," he said.
However, concerns remain. "The fundamental economic outlook for the country has not changed. While GDP growth is currently strong, consensus forecasts for 2018 and beyond show real growth falling below 1% annually as all the well-known limitations of the Japanese economy (such as demographics, productivity and debt levels), remain. And it's not clear how much further margins can rise," said Mr. Morris. BNP Paribas runs €2.3 billion ($2.7 billion) in Japan equities.