Japanese stocks: key diversifier

International investors have been underweight Japanese equities since 2005, but their allocation is beginning to edge back towards the benchmark weight.

Our long-term forecasts suggest the shift makes sense.

We expect Japanese equities to deliver an annual return of over 10 per cent in the next five years, outperforming US equities and almost matching returns from emerging equities in dollar terms yet with far lower volatility.

This is in large parts due to the yen appreciation we anticipate over the period, but it also reflects Japan Inc’s spending power and its impact on returns.

The country’s corporate sector is flush with cash. The cash-to-revenue ratio stands at its highest level in more than half a century, and companies are still generating even more cash with similarly record levels of free cash flow.

The Yen:

Sceptics might argue that the currency appreciation that comes with higher interest rates augurs badly for Japanese companies and their shares.

It is true that the yen looks set for a sustained appreciation. We expect it to strengthen beyond JPY130 per dollar, thus moving closer to its fair value which is estimated at around JPY108 based on our proprietary exchange rate determination model.

Yet the idea that a strong yen is bad for Japan Inc is wide off the mark.

The negative correlation between Japanese stocks and the yen has only held for a particular period in the late 2000s. This is no longer the case.

Growth and Export:

Japan’s earnings prospects are not as dependent on export growth as they used to be.

The exports of goods and services contribute less than 20 per cent to the country’s economic output. What is more, Japan’s share in global exports has halved to 3.4 per cent since 1998 as production moved offshore.

Companies that are sensitive to increases in capital spending and consumption are likely to benefit the most from the new environment of rising prices.

They include machinery, factory automation, housing and retailers.

As for banks, which tend to benefit from tighter monetary conditions, we are beginning to take profits as the sector has already gained nearly 50 per cent since the beginning of last year.

As Japanese households and companies wake up to the return of inflation for the first time in 40 years, investors should be prepared for a radically different economic landscape, where a virtuous circle of rising prices and higher spending and investment boost the country’s stocks.

If you would like to learn more about our view on Japan, please join us virtually on Tuesday, March 7th at 11.00am.