The case for Japanese equities

We see further strength in Japanese equities after their recent rally, given an encouraging earnings outlook, relatively low valuations and a stable yen under Japan’s ultra-easy monetary policy.

Japanese equities are approaching peaks they have struggled to climb over in past decades. Is this time different? We see reasons for optimism. Valuations (green line) are lower than at previous high points in stock market performance (blue line). Moreover, Japanese stocks appear inexpensive on the global stage — trading at a 20% discount to U.S. peers on a 12-month forward price-to-earnings basis.

More than just valuations

Low valuations alone are not a reliable buy signal, yet we find an improving earnings outlook adds to the appeal of Japanese equities. We expect Japanese companies’ earnings growth to hit a three-year high in 2017. A sustained global economic expansion is boosting overseas earnings, while wages are rising just enough to bolster domestic consumption without eroding profit margins. The recovery in earnings also reflects companies’ greater focus on shareholder returns. Profitability among Japanese companies has been improving, but remains well below that of other developed markets. Return on assets, a gauge of corporate efficiency, has risen back toward precrisis peaks, and Japanese companies have undertaken significant deleveraging. Earnings, meanwhile, are rising faster than dividend payouts and buybacks, and this provides considerable scope to improve shareholder returns.

The BoJ’s equity purchases and domestic investors’ increasing preference for stocks provide further support. Our analysis shows Japanese equities remain far from a crowded trade, as foreign investor inflows have recently subsided. A further support is the BoJ’s ultra-easy monetary policy, which contrasts with a normalizing Federal Reserve and a looming step change in the ECB’s monetary stimulus. We see this helping keep the yen in a stable trading range. Any sharp rise in the currency is a main risk to the Japanese equity rally.

Bottom line: We are overweight Japanese equities (currency-hedged in the case of non-Japanese investors), and prefer stocks with foreign earnings growth.