Japan — Q4 Update
As 2017 draws to a close, most risk assets have outperformed year-to-date amidst the best global economic backdrop we’ve seen in years. The Japanese stock market stands out as one of the star outperformers, having returned 22% year-to-date against the MSCI World’s return of 19%. In this week’s In Focus, we explain in detail some of the tailwinds for Japanese outperformance, and how Japan fits into our current regional equity allocation.
With 60% of revenues derived domestically, one major tailwind for Japanese stocks has been the health of the domestic economy. Japan is currently enjoying its second longest period of expansion in post-war history, with Q3 GDP growth printing at 1.7% y/y, above what most experts deem to be trend growth. Initially, the upturn was driven by broad-based export demand from key trading partners like China and the US. However, there is now growing evidence that domestic demand is also finally gaining traction. Domestic business confidence has risen to its highest level since 1991, mirrored by measures of consumer confidence. The latter speaks to improving income and employment conditions with the unemployment rate falling to a 23-year low of 2.8% and the jobs-to-applicants ratio nearing all time highs. This, in turn, is helping to drive consumer spending.
Meanwhile, both fiscal and monetary policies have been, and are expected to remain, supportive of growth. The ruling coalition’s solid victory in the October parliamentary elections has given Prime Minister Abe the go-ahead to proceed with a new ¥2 trillion supplementary budget. While the last supplementary budget centred on infrastructure investments and disaster relief, the next is likely to be focused more on populist measures such as educational support for lower income households and increased healthcare spending on Japan’s rapidly ageing populace. Moreover, the Abe administration is mulling corporate tax incentives in order to encourage firms to boost wages and productivity-enhancing capex. These fiscal plans are expansionary in nature, and should, at the margin, provide an additional boost to growth on implementation.
On the monetary side, while Japan has managed to pull itself out of sustained deflation, core inflation remains well below the Bank of Japan’s 2% target. Therefore, we see no change to the Bank of Japan’s accommodative stance as we move into 2018.
The outlook for Japanese growth remains positive looking into 2018. To us, the Japanese economy is likely to continue to benefit from robust domestic demand, expansionary fiscal and monetary policies, as well as further external demand from major trading partners.
The positive economic backdrop – both domestically and externally – has coincided with improving corporate profitability for Japanese companies. Corporate profits have rebounded strongly from the 2016 downturn, and are at post-Crisis highs. As expected, the pro-cyclical sectors like technology and industrials have led the earnings charge, while the low yield environment has ensured that the financial sector has lagged. Dividend payout ratios have also risen substantially – a nascent sign that government reforms to alter corporate behaviour and improve shareholder returns may be starting to bear fruit.
Structurally, the Japanese equity market is highly pro-cyclical, with consumer discretionary, industrials and technology stocks making up more than half the market capitalisation. The corollary is that earnings leverage to improving economic conditions is strong, compared with other markets. Our outlook for continued domestic economic expansion and a supportive external backdrop heralds further upside for aggregate profitability over the medium term.
Japan’s outperformance this year hinged on some of the common macro themes we’ve witnessed in global equity markets this year – a robust domestic backdrop, strong external demand, and rebounding corporate profitability. Based on our preferred lead indicators, we think that global growth and trade momentum should be sustained as we move into 2018 – a net positive for the more cyclically-levered Japanese equity market. All of this argues for investors to have some, primarily hedged, exposure to Japanese equities. However, for the moment, we retain larger relative positions in Continental European and US equities, where we still have higher conviction in the path of corporate profitability.