- Japanese equities have had a challenging year but the outlook moving forward has improved. We see a combination of catalysts in 2H22 and an attractive 25% upside potential by Mar-2024.
- The re-opening of borders and a positive turn in the China situation will be significant macro catalysts, setting up for a possible sequential growth rebound for Japan in 2H22.
- Corporate earnings remain supportive given tailwinds from i) strong pricing power, ii) robust sales growth, iii) weak yen boosting foreign income, and iv) earnings strength from the Consumer, Communication Services, and Health Care sectors.
- Valuation multiples have de-rated significantly over the past year and are currently undemanding. We see room for a re-rating given the catalysts and gradually improving investor sentiment.
Japanese equities have had a challenging year. Faced with a stubborn domestic Covid-19 situation, an equally challenging global macro backdrop, and extreme yen weakness, Japanese equities (gauged by the Nikkei 225 Index) are down by -14.8% so far this year (as of 31 July 2022, in SGD terms).
Despite these challenges, we see the potential for Japanese equities to perform better in 2H22 as several equity catalysts emerge. In this article, we outline why we remain positive on the region’s equities, as well as the factors that will drive further equity upside.
Re-opening of borders is a significant growth catalyst, policy remains supportive
Japan targets to gradually reopen to international travel in 2H22. While it is still in the pilot phase (controlled tours), we believe it is a step in the right direction. In 2019, Japan’s tourism sector contributed around 7% of its GDP, one of the largest globally (Chart 1). While it is unlikely for tourism to hit pre-Covid levels this year, a partial rebound can have significant implications.
Based on forecasts from the World Travel and Tourism Council (WTTC), the recovery of Japan’s tourism sectors could reach 95% of pre-Covid levels by end-2023, implying a contribution of roughly 5% of GDP. Even if Japan’s re-opening occurs slower than expected, we are seeing an increase in domestic tourism as locals learn to live with Covid-19. A shift like this is still positive for the economy, albeit on a smaller magnitude than a full re-opening. Thus, we view the re-opening of borders to be a significant – and timely - growth catalyst for Japan in 2H22, considering the tourism receipts and positive spill-overs on the labour force and tourism-related investments.
Chart 1: Japan’s tourism sector is a major contributor to its growth
Japan’s growth is further supported by a dovish monetary policy backdrop (fiscal policy remains relatively neutral). The Bank of Japan (BoJ) remains accommodative given that the local inflation data remains tolerable, while the experiences from decades of deflation still weigh heavily on policy decision. In our view, the BoJ will most likely stick to their dovish stance until inflation data surprises to the upside and greatly exceeds the BoJ’s forecast for a sustained period of time.
We thus expect the current accommodative monetary policy to continue, which in junction with a potential re-opening, a rebound in household spending, and an improving China situation (as outlined below), sets up for a sequential growth rebound for Japan in 2H22. As compared to other developed market peers like US and Europe, which are facing softening growth and a lack of growth catalysts, Japan possesses a much more positive growth-policy mix in 2H22.
The China factor
A positive turn in the China situation - which entails a further easing of restrictions and the continuity of policy support – will be positive for Japanese equities given the close economic linkage. China accounts for almost 40% of Japan’s total tourism spending in 2019, making it the single largest spending by a foreign country. The allowance of international travel for Chinese nationals, even if partial or controlled, will have an outsized impact on Japan’s tourism receipt.
China is also one of the largest import and export partners for Japan. A recovery in China’s demand and an easing of supply chain bottlenecks can drive a rebound in China-bound exports, such as autos, machineries, and electronics shipments, all of which are key Japanese export sectors. China’s production levels of export goods should also rebound, thereby supporting the production of Japanese goods using China imports, which account for a notable proportion of Japan’s total manufactured goods.
Aside from direct economic impact, a reversal in China’s economic situation is likely to support sentiment towards regional equity markets. This is captured by the positive correlation between Chinese equities and the various Asian equity markets, suggesting that a positive price movement in the former will likely lead to directionally similar movements for the latter, and vice versa. Amongst Asian equities, Japanese equities (gauged by the Nikkei 225 Index) have one of the highest correlation with Chinese equities. This implies that moves in Japanese equities tend to be larger than most regional peers and thus, the former may see stronger positive gains should a positive China story play out.
Chart 2: Within the Asian equities space, Japanese equities are more correlated to China equities
Supportive corporate earnings backdrop
After a double-digit earnings rebound of 21% in the previous fiscal year, earnings growth for Japanese equities is likely to normalise. We expect the earnings recovery to continue but at a moderate pace of 7-8% over the next two years. Despite headwinds from rising input costs and softening global demand, corporate earnings remain firmly supported by the following earnings tailwinds.
I. Strong pricing power
Japanese companies have started to raise prices of goods to keep up with mounting input costs. This is reflected in the leading au Jibun bank Japan PMI report, which indicated that output prices for both Japanese goods and services have risen at an unprecedented rate since May. This was further confirmed in the recent Tankan survey (a prominent survey conducted by the BoJ), which reported that output prices for both large and small companies have risen at a faster pace in 2Q relative to 1Q22 (Chart 3).
Japanese companies are also seemingly successful in passing costs to consumers. Signs of this can be seen from the narrowing spread between Japan’s producer price index (PPI) and consumer price index (CPI) over the past three months. This happened as CPI has picked up sharply, outgrowing the PPI, which suggests that consumer prices are rising as a result of the pass-through of higher input costs from businesses. Despite the rise in consumer prices, sales growth on aggregate (gauged by the Nikkei 225 Index) has been on a robust uptrend – as outlined in the section below – and sales estimates have seen minimal negative revisions. This further suggests that Japanese consumers have so far been able to absorb the price increases.
On balance, the ability of Japanese companies to raise selling prices rather successfully - without a material impact on sales – reflects a relatively high degree of pricing power. Thus, amidst the current backdrop of mounting costs, this attribute is a positive for corporate earnings.
Chart 3: Output prices for both large and small enterprises have risen at an extreme pace this year.
Chart 4: Japan’s PPI-CPI spread has been narrowing, suggesting that consumer prices have been rising as a result of the pass-through of higher costs from businesses
II. Robust sales growth
Japanese companies have enjoyed a strong recovery in sales over the past year. In this recovery cycle, sales have grown by a quarterly average of 9% year-on-year, exceeding the prior cycle’s average of 5%. In line with consensus, we expect sales for Japanese equities, on a per share basis, to trend higher in FY23, growing by 7% year-on-year (Chart 5).
We believe this is achievable and sales growth is likely to remain resilient due to i) a robust recovery in domestic demand, as well as ii) the strong pricing power of Japanese companies, as outlined above. In a time of rising input cost pressure, the resilient sales outlook and strong pricing power of Japanese corporates offer more protection from margin destruction. The aggregate gross margin for Japanese companies, which is near an all-time high, should also provide a substantial buffer against a further rise in input costs.
Chart 5: Japanese companies have enjoyed a stronger than average recovery in sales.
III. Weak yen boosts overseas income
The massive depreciation of the yen relative to major currencies has been a net positive for earnings. This can be largely attributed to the market composition of Japanese equities, which has high exposure to international revenue. An estimated 50% - 55% of companies from the Nikkei 225 Index derive at least half of their revenue internationally. Additionally, many of the largest-weighted companies (Fast Retailing, Tokyo Electron, Daikin Industries, FANUC Corporation etc.) are internationalised to a large degree and have high foreign revenue exposure.
IV. Firm support by the Consumer, Communication Services and Health Care sectors
The recent exit from a state of emergency (in May), alongside supportive fiscal and monetary policy, has jumpstarted the rebound in Japan’s domestic demand this year. The cyclical and domestically exposed industries such as Retail, Auto, Food and Staples, as well as Household and Personal Products are expected to see larger-than-index EPS growth rates across FY23-FY24, supporting the earnings growth of the broader market.
Earnings recovery in the Communication Services sector across FY23-FY24 is also expected to support index EPS growth. Three factors drive this recovery. Firstly, a rebound from a low-base (the sector saw negative earnings last fiscal year). Secondly, an expected robust EPS recovery for Softbank, the sector heavyweight, from prior fiscal year’s negative earnings. Lastly, a broad-based improvement in profit for Game publishers (Nintendo, Konami, Nexon) and internet companies (Z holdings). Similar to the prior fiscal year, Japan’s Health Care sector will again be a major contributor to index EPS growth across FY23 and FY24. Pharmaceuticals and health care equipment/ supplies companies, in particular, are expected to drive the sector EPS growth as they continue to see strong sales and improving margins, even in the face of slowing growth.
Table 1: Earnings growth across FY23 – FY24 supported by Consumer, Communication Services and Health care sectors
Source: Bloomberg Finance L.P., iFAST compilations. Data as of Aug 22.
Valuations at a steep discount - Possible set-up for a re-rating in sight
Japanese equities (gauged by Nikkei 225 Index) have suffered one of the largest valuation de-rating across major equity markets. Despite positive earnings revision last year, the Nikkei 225 Index has de-rated by more than -50% from its 2021 high of 28.5X. Japanese equities are currently trading at 15.6X based on FY23 earnings estimates, a gapping -24% discount to its long-term average (chart 6).
Chart 6: Japanese equities have de-rated significantly from its 2021 high
A closer look at the constituents of Nikkei 225 Index shows that the valuation gap is not skewed by larger-weighted companies. In fact, this valuation discount is rather broad-based as around 78% of Nikkei 225 Index’s constituents are trading at a discount to its 10-year average forward PE ratio (Chart 7).
Given the gapping valuation discount, the emergence of macro catalysts and supportive earnings outlook strongly support the case for a re-rating and thus, greater valuation-driven upside potential. This is reinforced by an observed retreat of pessimism regarding Japanese equities (as outlined below) which may act as an accelerant for a stronger re-rating.
Chart 7: Around 78% of the companies within the Nikkei 225 Index are trading at a discount
Pessimism surrounding Japanese equities are dissipating
Sentiment regarding Japanese equities have been rather pessimistic this year but we see signs of a gradual turnaround. A look at the options market for Nikkei 225 Index shows that the top options, based on open interest (total number of option contracts that are currently out in the market), are currently dominated by puts. The open interest for puts in the year-to-date has also risen at a faster pace than that of calls, suggesting that investors have been largely pessimistic, in line with the huge valuation de-rating seen this year.
That said, market data are showing an improvement in sentiment. First, foreigners have been buying Japanese equities (on a net basis) from 2Q onwards, after a period of consistent selling. Second, selling pressure from institutions and retail investors has also been receding around the same period, as suggested by a declining short sales to total selling ratio (Chart 8).
Chart 8: (Left) Foreigners have been buying Japanese equities in late-March. (Right) Selling pressure from institutions and retail investors have also fallen in the same period
Risks – Vulnerable to Covid and global growth risks
A serious resurgence of local Covid-19 cases and a faster-than-expected global growth slowdown are key risks for Japanese equities. We believe policymakers are tolerable of a temporal resurgence in local Covid-19 cases given the high vaccination rates, but a prolonged high case count may result in certain restrictions. This may dampen the nation’s economic momentum and the positive domestic recovery story.
We believe Japanese equities can digest a gradual softening in global growth, but a steeper-than-expected slowdown may also prove challenging. The region’s equities remain sensitive to global growth momentum due to its cyclical nature and a sharp slowdown in global growth may further weigh on earnings revision and growth.
Where will the yen go from here?
The yen has suffered significant depreciation against major currencies (Chart 9), largely fuelled by two dynamics. First, the policy divergence between the BoJ and global central banks. While overseas central banks have expeditiously raised rates to combat mounting inflation, the BoJ has artificially kept bond yields low with yield curve control (target of -0.1% for short-term JCB yield and 0% for 10-year JCB yield). This has led to a widening of interest rate spread between BoJ and global central banks, heaping depreciation pressure on the yen.
Second, a growing trade deficit due to higher energy import costs. Japan has continued to record a growing trade deficit given a weaker yen and higher energy prices. The trade deficit as of June stands at JPY 1,383 billion, down from a surplus of JPY 369 billion recorded a year earlier. This falling/ negative terms of trade (ratio of export prices to import prices) has – and continues to – weigh on the yen relative to currencies of its trading partners. While a weaker yen is generally positive for Japanese equities, we believe a depreciation of such extent can hurt equities.
Chart 9: Japanese yen has depreciated dramatically, with the REER around historically low level
Looking ahead, we still expect near-term depreciation pressure to persist but believe the yen weakness has hit an extreme level. Thus, we believe further yen downside may be limited given i) the dialling back of expectation for higher policy rates of major central banks as growth slows (this can narrow the policy divergence even as BoJ maintains an accommodative stance), ii) the rising possibility of a political pushback given elevated inflation and a weak yen, leading to a stance change in the BoJ, and iii) a potential pivot to back to the yen, a traditional safe-haven currency, as global recession fears and political risks rise.
At this juncture and current level, we also expect the upside (of a yen appreciation against major currencies) to be significantly larger than its downside. In our opinion, the longer the yen sits at such extreme level, the higher the risk of a precipitous rebound. For the above reasons, we now recommend an unhedged approach to Japanese equities, maintaining exposure to the yen.
Attractive upside potential for Japanese equities
Applying our designated fair PE ratio of 18.0X on EPS projections for the next two years, we project a target price of 35,000 for the Nikkei 225 Index by Mar-2024. This implies a 25% upside potential should earnings and valuation expansion materialise, with the latter driving the bulk of the upside. On balance, the outlook for Japanese equities has improved given the potential emergence of catalysts in 2H22 onwards and we now expect a stronger upside potential. Relative to other developed markets, such as the US and Europe, the outlook for Japanese equities is also stronger in our view. Therefore, we maintain a 3.5 Stars “Attractive” rating for Japanese equities.
For investors who wish to seek exposure to the Japan’s equity market, we recommend the iShares iShares MSCI Japan ETF for a passive approach. For an active approach, we recommend the JPMorgan Funds - Japan Equity A (dist) SGD, opting for the unhedged share class to maintain exposure to the yen.
Chart 10: Earnings forecast and price performance of Nikkei 225 Index
Table 2: Projections for the Nikkei 225 Index
|
Japan (Nikkei 225 Index) |
FY2022 |
FY2023 |
FY2024 |
|
PE ratio (X) |
16.8 |
15.6 |
14.6 |
|
Projected earnings growth (YoY %) |
20.7% |
7.6% |
6.6% |
|
Projected Earnings Per Share (EPS) |
1,667 |
1,795 |
1,913 |
|
Target fair price (Based on 18.0X Fair PE ratio) |
- |
- |
35,000 |
|
Potential upside (%) |
- |
- |
25.0% |
|
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 9 Aug 2022. *Fiscal year from April 1 to March 31 |
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The Research Team is part of iFAST Financial Pte Ltd.
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