Over the course of the year, the Japanese stock market has continued to rise from its March low point, helped by a general improvement in investors’ risk appetite and the release of more positive economic data.
By October, the Topix Index had reached its highest level in a year, helped by better-than-expected corporate results and a rebound in GDP following four quarters of economic contraction.
But the strengthening of the yen against the US dollar coupled with uncertainty about how the newly elected Democratic Party of Japan (DPJ) regulates the financial system has weighed on stock market returns since October. Small- and mid-cap stocks, which are mostly domestic-oriented and therefore not adversely affected by the stronger yen, have remained firm. Indeed, the TSE Mothers index, which follows high growth and emerging stocks, had risen nearly 12% in sterling terms to the end of November, significantly outpacing all other Japanese equity indices, which were all in negative territory.
Turning to political developments in Japan, following its landslide victory, the DPJ formed a new coalition with the People’s New Party and the Social Democratic Party. The new administration aims to stimulate domestic demand through direct assistance to households, such as granting childcare allowances, abolishing road tolls and reforming subsidies for farmers. This policy emphasis on supporting the nation’s living standards could improve productivity and lead to a growth in domestic demand, although it will take time before such changes emerge. In terms of the currency, we think the new government favours a stronger yen, which would increase the buying power of Japanese households. It would also facilitate the downsizing and restructuring of manufacturing export industries with excess production capacity.
Looking ahead, although Japan’s economy grew for the first time in five quarters in Q2, we believe the economic recovery will continue to be slow due to the worsening employment situation.
Against this backdrop, we think the Japanese stock market will move within a narrow range. In our view, large-cap manufacturers and cyclical stocks, which previously benefitted from the weak yen, high commodity prices and the sharp growth in exports, are unlikely to sustain their strong performance given the recent strengthening in the yen.
We believe since March of this year, market sentiment has changed in favour of domestic-oriented growth companies, and that their strength will become more prominent over the next 12 to 18 months, particularly in view of their attractive valuations. Over the longer term, we also believe the DPJ’s focus on policies to foster spending by consumers and domestic demand should also be supportive of its investment strategy.
Hideo Shiozumi is portfolio manager of the Legg Mason Japan Equity fund
