The Land Of The Rising Sun – An Update!

• Strong earnings momentum seen in the Japanese equity market
• Japanese exports have been strong; positive trend expected to continue
• Favourable political backdrop for the economy
• Equity market valuations are undemanding, with potential upside higher than other developed markets under our coverage

Positive Earnings Momentum In Japan!

Corporate Japan is still halfway in through reporting their 3Q 17 results, with the earnings season lasting between 27 October and 14 November 2017. As of 6 November 2017, 133 out of 225 of the Nikkei 225 Index’s companies have reported their results, and among those who have reported, 72% of them have beaten their third quarter sales targets, while 62% of them have bested their earnings targets. We note that in 2Q 17, earnings growth of Japanese corporations have been broad-based in nature, with most sectors reporting healthy double digit growth rates.

Chart 1: Japanese Companies Have Beaten Estimates Year-To-Date

More attention could be focused on the industrials and consumer discretionary sectors, as they are the main components of Japanese equities. As expected, the industrial sector performed well in 2Q 17, aggregate earnings surprise was 12.9% and year-on-year growth is of 45.8%. Upgrades to earnings forecasts for the sector were seen post-earnings announcement, with a magnitude of 11.5% from 28 July to 15 September. We remain optimistic towards the 2H earnings for the sector given that the exports of machinery is still going strong and the theme of global recovery continues to support the industry’s demand outlook.

Not differing from 2Q 17, we expect the strength in demand to continue stemming mainly from China and the ASEAN region, followed by the US. China’s demand for Japanese machinery now seems structural in nature, with the ongoing supply side reforms as well as rising domestic wages requiring the industrial sector to upgrade and expand their machinery so as to keep costs low enough to retain its export competitiveness. The demand is further buoyed by the central government’s “Made in China 2025” initiatives, which largely advocate industrial players to invest more in high-end equipment.

ASEAN’s demand is a less structural and more cyclical in nature. Indonesia seems to be an exception, with the government trying to shift from a consumption-led economy into an investment-led one, while companies are repairing their return on assets levels from 2016’s levels, hence contributing to high percentage growth in their orders to Japan. The demand from other ASEAN countries seemingly mirror the pattern in the global economic environment, growing along with the global recovery as their domestic economies improve. As we see no immediate reversal in global growth yet, the strengthening global economy should continue to support capital investment, strengthening producer sentiment.

Japanese automobile manufacturers earnings growth came in as a surprise, with Toyota and Honda managing to achieve 13.2% and 18.7% earnings growth respectively, a roughly 30% surprise to the market. However, both companies recorded poor operating profit growth as the strong earnings figure originated from investment in affiliates, while its core business is struggling. Good news for the sector however, is that the market doesn’t expect much from these companies in 2H 17. The consensus expects minimal growth or even losses coming in for the next two quarters, while their stock prices greatly lag the performance of the headline indexes. Hence even if they deliver poor results in the coming earnings announcement, it would likely not have an adverse impact on the market.

Positive Macroeconomic Trends

Exports Remain Supported

Exports remained strong, with September's exports rising by 14.1% year-on-year. By now, we would like to state that it is more important to understand the export figures on a country level, instead of the headline number. For exports towards China and the ASEAN region, with respective demand for industrial upgrades and expansion showing ongoing positive momentum, they shall continue to provide positive contribution to export growth in the near-future even when the low base effect starts to fade out in upcoming month, as their main imports are from Japan and that their demand originates from a structural reasons instead of a cyclical trend.

Exports towards the US is however, in a weaker state. The export amount looks mostly static with no visible upward momentum after the rise seen at the end of the last year. Exports of machinery, much like the case for China and the ASEAN region, is growing rapidly with positive momentum, presumably because manufacturers are trying to boost production at the current juncture. Yet exports of automobiles seems to be static, matching the consensus’ caution on producers’ earnings outlook.

With demand for machinery in mind, we believe export figures will remain positive, but the magnitude shall be reduced when the low base of 2016 fade out, especially when exports of automobiles to the US struggles to grow. The outlook for the industrials sector remain supported.

Wages & Consumption

Growth of real contractual wages remain largely minimal, with the latest year-on-year growth being 0.6% and the data series spending most of its time hovering around 0.5% in 2017. Growth of non-scheduled cash earnings (wage payment for overtime) however, improved greatly with its year-on-year growth reaching 1.3% as of August. The higher overtime pay-out, combined with the increasing participation rate and low unemployment rate (2.8% as of August 2017), suggests that the labour market is tightening, which should eventually lead to contractual wage growth.

More jobs and higher aggregate income lead to stronger consumer confidence and higher consumption. The consumer confidence index reached 43.9 by September, as compared to 42.8 at the start of 2017. The data is rising consistently, albeit at a slow rate. Retail sales on average grew by 2.0% for April to September, historically a significant level, presumably because of stronger willingness in spending from consumers.

One impending event to watch would be the raising of the sales tax by 2019. Based on previous observations, although the introduction of sales tax often affects domestic consumption afterward, it usually boosts the retail sales figures before-hand as consumer stocks durable goods ahead of price hike. 2018 therefore is set for a spike in retail sales if the tax hike is impending.

Areas to look for would be companies producing household appliances and other durables, together with companies in retail business. However, they are not heavyweights in the market index.

Sentiment Index

The Japan Eco Watcher outlook survey, serving as a probe of economists' confidence towards Japanese economy, stay firmly above neutral level of 50.0 after May this year, with the latest August reading being 51.0, indicating optimism, presumably because of strong external demand and relatively strong domestic consumption.

The Manufacturing PMI largely stayed between 52.0 and 53.0 since the start of 2017, September's preliminary figure is now 52.9. September's report supports the ongoing strength for exports, with increasing new orders and improvement in positive sentiment.

FX – Mild Depreciation Against the USD Expected

With inflation still far away from the 2.0% target, and economic data probably pointing to an eventual rise in inflation, there is no reason for the Bank of Japan (BOJ) to scale back its stimulus measures now. We expect the BOJ to maintain its yield curve control policy and keep the yield of the 10-year JGB at around 0.0%. Given that the US policy-makers are maintaining a rate hike trajectory regardless of the pace, the JPY is likely to move lower against the USD based on widening rate differentials.

The imminent factors affecting the JPY would be the Federal Reserve's upcoming meeting in December and the progress of US tax reforms. With the upcoming Fed rate hike widely expected by market participants (as high as 92.3% as of 6 November 2017), we may only see a minor depreciation of the JPY against the USD when a hike is eventually announced.

Favourable Political Backdrop

We have been stressing the fact that there is no need to worry for Shinzo Abe's leadership in recent times, the snap election that took place on 22 October confirmed our view. As Abe's ruling coalition secured two-thirds of congress's seats, expansionary fiscal and monetary policies are here to stay. Economic stimulus are poised to be more intensive than before as Abe still need to win back his approval rate to secure his fourth term as Prime Minister, which is subject to internal challenges by September 2018 if his cabinet's approval rating dipped again.

There are two main implications from PM Abe's victory. First one would be with regards to the JPY 2 trillion fiscal stimulus which he mentioned before the snap election; supposing that the stimulus package would be carried out since 2018, boosting the economy by creating facilities and job vacancies related to child care and education. The action undoubtedly would be positive for the economy.

Second implication would be the scheduled sales tax hike by October 2019, whereby PM Abe claims that the source of funding for the above mentioned stimulus would come from the tax hike's implementation, and that he would raise the tax unless economic data adversely deteriorates. It is difficult to judge whether the tax would be delayed for another term, as it happened twice before, yet unless citizens are convinced that the tax hike would be delayed, they would start to spend early in face of expected increases in prices. From 2014 tax hike's experience, the acceleration in sales growth starts as early as a year ago, this could boost consumption and related companies' earnings by 2H 2018, acting as an incoming positive catalyst, despite its negative impact after the introduction of hike.

Valuations Are Undemanding!

We would now argue that the current economic environment looks similar to the 2013 to 2015 period. Much like the mentioned period, we see corporate earnings rising, while the market has been slowly revising up their earnings forecasts. There are also improvements in corporate and economist sentiment, which both rose from pessimistic levels to optimistic levels, and finally, both periods have witnessed strong exports growth (1H 14 had weaker data, but it quickly recovered).

Arguably the two periods held different growth catalysts, the previous growth came mainly from the sharp depreciation in the JPY, while the current period is anchored on global economic recovery and a consistent demand for machinery from China and the ASEAN region. But still, the similar improvement in earnings and sentiment means the period’s valuation cycle can be used as reference for current valuation.

Chart 2: Nikkei 225 Index Valuations Since 2011

We opine that further earnings upgrades could come in, which would bring down overall aggregate valuations. By duplicating the earnings upgrades seen since June to the present and applying it to the coming two quarters, the forward 12-month PE ratio will be an estimated 19.0X, making potential total upside an estimated 17.6% return by end-2019. As of this current juncture, the Nikkei 225 Index is trading at an estimated PE ratio of 17.5X for FY 2018 and 15.7X for FY 2019, as compared to its fair PE ratio of 18.5X.

This potential upside is attractive relative to the expected returns from other developed markets like the US and Europe. Additionally, the chances of realising these returns appear high amid a positive macroeconomic backdrop and improving market sentiment.

In summary of all points mentioned above, we believe Japan’s macro environment shall improve further in the coming quarters, with earnings for industrial and consumer-related companies likely to continue delivering, setting the foundation for the equity market to go higher, given that valuations are not demanding. We retain our star ratings for Japan at 3.5 Stars “Attractive”, and recommend investors to remain overweight in Japanese equities within their developed markets allocation.

The Research Team is part of iFAST Financial Pte Ltd.