Upgrading Japan stocks
Japanese equities did not escape completely unscathed in the year-to-date selloff in risk assets – yet are poised to end the first quarter as relative outperformers. Japan’s benchmark TOPIX index is the only developed market benchmark up on the year compared to the 3-7% declines for U.S. and European benchmark indices, according to Refinitiv data as of 29 March. In our latest Global Outlook update, we add to our overweight to Japanese equities amid a broader preference for equities following the knock risk assets have suffered – first by policy confusion amid supply-driven inflation earlier in the year and exacerbated by the sentiment hit and energy shock due to the Ukraine conflict. For Japan, we see the relatively benign domestic growth backdrop, rising dividends and buybacks and supportive monetary and fiscal policies as reasons to add to our overweight and remain invested through a period of heightened uncertainty.
A relatively benign growth backdrop
We see renewed activity restrictions due to rising Omicron infections as only delaying rather than derailing Japan’s restart. The shock from higher commodity prices – from oil to food grains to industrial metals – in the aftermath of Russia’s invasion of Ukraine is likely more important. We believe the shock will weigh on growth and stoke higher inflation globally. Yet we see this impact to be felt most starkly in the euro area, and less so in other developed regions such as the U.S. or Japan. More broadly, strong underlying growth momentum – driven by the powerful post-Covid restart – has provided something of a growth cushion for the global economy going into the conflict. Data for the quarter ending December 2021 showed Japanese GDP growing at an annualized rate of 4.6% with spending on services particularly strong and private consumption expenditures growing at an annualized rate of 10%, according to Bloomberg data. The government is also preparing additional spending measures to soften the impact of the higher commodity prices. More on this below.
Corporate results for the quarter ending December 2021 showed Japanese companies on a firm footing. Aggregate revenue for TOPIX companies grew 5.7% and operating profits rose 24.7%, according to data from the Ministry of Finance’s Financial Statements Statistics of Corporations. The manufacturing sector saw earnings rise 22.1%, suggesting companies were able to absorb higher energy costs. Importantly, Japanese companies’ operating leverage – a measure of how efficient companies are at turning sales into profits – is running at a 25-year high, according to Refinitiv data. This suggests that even with low-to-mid single digit revenue growth expected in the coming quarter, companies can absorb higher costs and potentially generate profits that could surprise on the upside.
Strong results spur shareholder returns
Strong results are spurring companies to boost dividend payouts and increase share buybacks amid market weakness, in our view. This adds the kicker of attractive cash yields on top of fair valuations. See the chart. Our estimate of the equity risk premium – our preferred valuation gauge that considers the outlook for both interest rates and earnings – remains supportive across DMs, including Japan.
Supportive policy – monetary and fiscal
The Bank of Japan has shown its commitment to defend its yield curve control target of 0.25% on 10-year Japanese government bonds. This is likely to keep Japanese interest rates low relative to the U.S. and Europe where expectations for monetary policy normalization have snapped back. That backdrop also maintains the relative appeal of Japanese equities over government bonds and credit.Japan is also poised to announce additional stimulus to cushion the economic blow from higher commodity prices in the aftermath of the Ukraine war. The country’s parliament approved a record U.S.$900 billion state budget for the upcoming fiscal year to offset the impact of Omicron, rising social security and national defence costs. The government plans to set aside 5 trillion yen ($42 billion) as reserve funds for economic stimulus from the pandemic, the same amount allocated in the previous fiscal year. The government also plans to relaunch its “Go to travel” campaign that subsidises domestic travel.
The key risk for Japan’s equity market, in our view, remains a persistent global slowdown, given the export-oriented business of its large companies. That means the market remains vulnerable to global growth scares – such as the ongoing one following the Ukraine invasion. We see energy prices as the main transmission channel for the macro-outlook and risk assets during the new supply shock from the sanctions on Russia. We see the impact on growth outside the euro area as relatively limited. Underlying growth momentum remains relatively healthy with global manufacturing PMIs still above 50 according to March data from IHS-Markit.