Merrill Lynch's O'Neill: Japan market falls 'excessive'

Japan's manufacturing sector has beaten expectations following March's earthquake and tsunami, said Bill O'Neill, chief investment officer of Merrill Lynch, who sees further upside in Japanese equities.

Industrial production in April began to recover from a 15% fall in March. Manufacturers are now expecting an 8% increase in production in May and 7.7% in June, by which time production should have recovered to approximately 95% of the pre-quake level, data from the investment bank shows.

Consumption is expected to rebound, with April's consumption numbers up 2.4% on the month following a near 5% fall in March. However, output fell 3.5% year-on-year in the first quarter and is likely to drop again in Q2, according to Merrill Lynch research.

However, O'Neill is more bullish on the outlook for the second half of 2011.

"GDP is expected to expand about 6% on average in each of the third and fourth quarters. From recent positive economic data, we think this stronger outlook for the second half of 2011 is likely to materialise," he said.

Despite the positive economic data, O'Neill pointed to headwinds still impact Japan's post-earthquake recovery, such as the mandatory cut in Tokyo's electricity usage, which will constrain production, and the deterioration of the political landscape.

O'Neill branded the 2011 earnings estimates numbers for Japan as ‘excessive'. The figures project a fall of 16% following the earthquake.

"Corporate data from Q1 indicates the downgraded earnings estimates overstate the likely corporate impact. The market does not appear to be discounting the recent improved production data or the possibility the economic effects from the earthquake are transitory," he added.

Tailwinds include stronger earning results from automakers this month in addition to reduced risk of further earnings downgrades. Fiscal, structural and financial imbalances should maintain pressure on the yen to weaken against the US dollar over the medium term, O'Neill said.

"Two factors supporting a stronger yen against the greenback have been continued risk aversion and negligible interest rate differentials as the Federal Reserve has looked more like the Bank of Japan in recent years. We expect the support from both these factors to mitigate through the end of the year."

John Millar, manager of Martin Currie's £83m Japan fund, also forecasts a sharp recovery in capacity utilisation and industrial production.

"This recovery is progressing quicker than the market had initially expected, especially in the car and technology industries," he said.

Millar pointed to concerns over global demand recovery, especially from the US and Europe, but said attractive valuations of Japanese stocks should spur demand.

"The market has now fallen nearly 10% since the disaster, resulting in very attractive valuations for high quality companies with strong business models - as with Toyota, which has been trading close to book value," he said.

"The prospect of a weaker yen provides another potential catalyst. With most other central banks tightening, the Bank of Japan has signalled its willingness to boost liquidity, including outright purchases of equities. If the yen weakens, this will enhance the expected rebound in earnings substantially - especially in the manufacturing sector," Millar added.

Japan's stock market plummeted 6.2% immediately after the earthquake, dropping from about 10,500 to 9,620 points. The Nikkei 225 Tokyo index has recovered some of its losses and has been trading at an average of 9,500 since, according to FT data.