We have been backing Japanese equities for the past two or three years, since Prime Minister Abe’s “three arrows” of fiscal stimulus, monetary easing and structural reforms began. Arrows one and two have proved effective and, after decades of false dawns, a stimulus-pumped Japanese equity market has finally started to deliver strong returns.
Since the start of the year, Japanese stocks overall have gained 18% in yen terms, and in April the Nikkei 225 Stock Average closed above 20,000 for the first time in 15 years. The broader Topix index also reached its highest level since November 2007. So does that mean it is time to sell? I think not. If anything, Japan is more interesting today than it was a year ago. Like the JPM Japan fund managers, I’m quite bullish, as there are a lot of positives coming together at the same time.
While the market has enjoyed strong gains, it is still not expensive, and the price to book ratio, which set a record low in 2009, remains at historically low levels. This means there are still good pockets of value to be found. For example, there are some great opportunities in the financials sector, which has now surpassed the gold bear market of 1981 to 2003, representing one of the great bear runs for a main asset class. As a result, the Elite Rated GLG Japan Core Alpha fund now holds a significant overweight in banks: 23.5% versus an 8.9% weighting in the benchmark. The yen is also at a 40-year low.
It's also worth remembering that the third arrow, structural reform, is not one big policy but actually lots of little ones and will take time to implement. Now is not the time to lose patience. In the meantime, there are other positive factors which could lead to the market continuing to do well: stable politics for the first time in a long time; the central bank is desperate to get achieve sustainable inflation; unemployment is now 3.4% so wages are finally rising (the big banks have increased wages for the first time in two decades!); earnings momentum is way ahead of anywhere else in the developed world and two codes have been introduced – stewardship in February 2014 and Corporate Governance next month.
David Coombs, manager of the Rathbone Multi Asset Portfolios is of the same mind, having recently moved to an overweight position in Japan. Abenomics aside, David has been looking at whether improvements in corporate governance (including the introduction of the new code) which has long been an issue, are going to drive a re-rating of the Japanese market.
Today more than 70% of the Tokyo Stock Exchange (TSE) companies have an external director, compared with 50% just five years ago. This could potentially drive a redistribution of cash to shareholders, and perhaps steer households into stocks. There is clearly pent up demand, with cash representing around 53% of household assets. That figure is closer to 75% for 30 to 39 year olds. Alex Treves, head of equities for Japan at Fidelity Worldwide Investment, who shares this view on corporate governance improvements, believes the market has underestimated the progress made in this area.
Some external risks remain, such as concerns about a cyclical downturn in US activity, the deflationary threat in the eurozone, and a hard landing scenario in China. However, investors hungry for diversification, may be interested to learn that Japan has, over the past three years, had the lowest correlation with global equities of any of the major developed markets.
The coordinated pro-growth policies, the changes in corporate behaviour that are occurring, and the fact it offers reasonable valuations in a global context all continue to support the case for Japan in my view. While there may yet be some near-term corrections, they could simply provide investors with good opportunities to increase their exposure to Japanese equities.