Will 2018 be Japan’s time to shine?

Japan has been a hot topic of discussion among investors recently. At the end of last year, the Japanese equity index – the Nikkei 225 – broke through of the 23,000 barrier for the first time in 26 years.

Will 2018 be Japan's time to shine?

In fact, the Japanese equity index has comfortably outperformed all other major regional indices over the last six months, with gains of 9.68% in sterling terms. This is a far cry from how the index has behaved over the longer term, with the Nikkei having reached its highest peak over the last 30 years back in 1990. So what is causing the Japanese market to bounce back?

Of course, Japanese prime minister Shinzo Abe has been rolling out his three-arrowed ‘Abenomics’ programme since he was elected in December 2012, which involves circulating more money into the system, increasing government spending to boost the economy, and rolling out growth policies to increase private investment. This is a factor in the improving performance of Japanese equities over recent years, with the Nikkei having returned more than 100% under Abe’s rule.

In terms of the rally we have seen over the last six months, however, the team at First State Stewart Asia believes it is the result of a continuing recovery in global trade, as well as the improving efficiency of domestic Japanese companies. Their research shows that, in aggregate, net profits during the first half of last year grew by 20% year-on-year, which was far higher than the consensus forecast.

 Too dependent on the yen?

Some investors may be a little apprehensive as to whether Japanese equities can sustain this rally because, over the past three decades, there have been many false dawns. But since Abe came to power, the economy has been improving – unemployment has been falling and businesses have benefited from greater global demand; this has perhaps made it more likely that the Japanese equity rally can continue.

However, investors have to be aware that currency plays more of a part in investing in Japanese equities than it does in most other countries. For instance, First State’s research shows that the performance of the yen and of the Japanese stock market diverged for the first time last year since the start of Abenomics.

While the export-led Japanese economy traditionally fares well when the yen is weak, First State argued that a strengthening yen has actually been known to coincide with positive company earnings growth in some previous market cycles. According to the team, this is because the exchange rate tends to be dependent on trade balance – the difference in value between Japan’s imported and exported goods – rather than company cashflows.

It also pointed out that the source of Japanese earnings has changed significantly over the years, with more and more of the country’s corporate profits coming from domestic-facing companies. This means that currency fluctuations bear less weighting on the performance of the market.

Too expensive?

Another sticking point among investors is the recent strong performance of Japanese equities. However, Ruth Nash, who runs the JOHCM Japan fund, pointed out that Japanese equities have actually been de-rated over the past five years, when comparing the returns of the Japanese stock market to company earnings per share.

“Given this prolonged period of economic and political stability, not to mention the huge improvements in corporate governance and profitability, a de-rating seems unjustified,” she said. “We expect 2018 to be the year in which the equity market finally begins to accept that the improvements seen over the past five years are not temporary.” 

Top picks for Japan exposure

In this area of the market, the FundCalibre Elite Rated T Rowe Price Japanese Equity fund might present itself as a good option. Manager Archibald Ciganer looks for companies with strong branding power or technological advantages, but have been undervalued by the broader market. His contrarian style has led to strong returns over the years, although investors will require a long-term time horizon to allow for the broader market to catch up with where he is seeking opportunities.

Another option could be the Elite Rated Baillie Gifford Shin Nippon investment trust. Headed up by Praveen Kumar, the trust looks for high-growth, small-cap stocks through bottom-up stock selection. ‘Shin Nippon’ means ‘new Japan’ – the trust focuses on disruptive, emerging or rapidly-advancing sectors to find the best individual opportunities. Investors should note that it is currently trading on a 6.2% premium to NAV.

Finally, Andrew Rose’s Elite Rated Schroder Tokyo fund has one of the best-resourced teams in the sector. The manager aims to capture market inefficiencies at an individual stock level, focusing on franchise strength and earnings visibility.

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