Kenichi Amaki, Portfolio Manager, Matthews Asia
I am usually not one for making predictions about how the Japanese stock market will end in 2017, but it is fair to say that heading into this year I am feeling quite bullish. This optimism is the result of several factors.
Over the years, the Japanese economy has faced many macroeconomic headwinds. This year many of them have turned into tailwinds. Improved PMIs, accelerating wage growth and the announcement that the Japanese government will expand fiscal spending for the first time in three years all bode well for the strength of the economy.
Then there is inflation. Japan has been stuck in deflation for most of the past two decades and even I anticipated that after few years of positive CPI growth, the economy would sink again into deflationary territory. However given the weakness of the yen, a potentially inflationary environment in the U.S. and elsewhere, along with rising commodity prices, in all likelihood inflation may actually accelerate this year.
At the margin this is good news for Japanese stocks and is a tailwind that frankly we have not had. It should be supportive of Japanese revenues, trickling down to earnings and eventually to share prices.
Two areas which are likely to benefit are retail and financials. Japanese retail companies underperformed last year, owing to expectations of a return to deflation and renewed price competition amongst retailers. However with a change in both currency and inflation expectations, those things might be viewed positively for the retail sector. At the same time with wage growth accelerating again I believe there is room for more consumption this year, which is good news for retailers. Meanwhile we have seen yield curves steepen globally, including in Japan, which should be positive for Japanese banks and life assurance companies.
Another tailwind is a weaker yen, at 115-120 per dollar. The first thing to say is that yen weakness is not a requirement for Japan equities to outperform, but it is helpful owing to its effect on corporate earnings. Prior to the U.S. election it was about 103-104 and depending on what actually comes out of the Trump White House it could go in all different directions. However I remain skeptical that it will weaken to as low as 125.
A final factor to be positive about is fund flows in Japanese equities. This tends to be quite short-term in nature, but there are reasons to be bullish. By the end of October last year international investors had sold almost two-thirds of what they purchased at the start of ‘Abenomics'. Meanwhile, the Bank of Japan will be buying 6trn yen of Japanese equities annually, while corporate share buybacks have been robust, hitting 5trn yen in 2016 and are expected to continue apace this year.
At the same time domestic pension funds are short of their target allocations for Japan, all of which combined means there is likely to be around 10-15trn yen of domestic buying into the asset class this year. If international investors change their attitude to Japan and decide to up their weightings, it could really propel the market upwards.
So what of the risks? The biggest one on the table relates to what will happen in the U.S. with President Trump. How many of his economic policies can he deliver on and how much is the Republican Party willing to compromise?
His protectionist policies could have a big negative impact, while any U.S. policy mistakes causing U.S. economic reversal are also a concern. If the fiscal stimulus underperforms or underwhelms, yet the Federal Reserve continue its hiking cycle it could hamper U.S. growth. Policy mistakes causing deflationary trends would also be a threat to the global economy and remove all the inflationary tailwinds we discussed earlier.
Such risk scenarios will inflict pain on all of US trade partners, not just Japan. Meanwhile unlike many other countries right now it has the benefit of political stability, with Abe boasting some of the highest approval ratings in the world, which is a final positive tailwind to end on.
For our latest views on investing in Japan, please visit https://global.matthewsasia.com/japanfund/
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