(October 11, 2013) – After several false starts, investors should believe that Japanese equities are primed to soar in value, driven by the end of deflation, according to JP Morgan Asset Management.
Head of Research for Japanese equities Kentaro Sasaki said there were several fundamental reasons why Japan’s economy will finally take a turn for the better, driven by Prime Minister Shinzo Abe’s economic stimulus plan.
In the past, loose monetary policy had been taken off the table too early, stalling the recovery and sending Japan back into a downward spiral, Sasaki said.
This time is different: Abe gained control of the upper house of Japanese politics over the summer, giving him a much stronger chance than his predecessors of forcing through his policy of growth-economics—dubbed Abenomics by the world’s press—and his commitment to ending deflation.
In addition, corporate earnings, which have up until recently been low, are expected to rise by 62% this year, driven by the depreciation of the yen.
As investors have been cautious about going into Japan, equities are currently undervalued, Sasaki continued, particularly given the fact that the end of deflation—which he predicts will happen in 2014—haven’t been priced in.
Return on equity expectations are 9% for 2013, compared to 5.4% in 2012, and are expected to rise to 9.8% or even 10% if deflation ends next year.
“If deflation ends, we should see a shift from cash to equities and real assets in household financial assets,” Sasaki said. “It won’t be a major shift, I should think it would gradually increase from the 6% equities we see today to 7% or 8%.”
“It is natural to think that there’s a great deal of caution around Japanese equities, but that’s good news as it means there’s still good opportunities.”
An end to deflation would also encourage corporates to stop sitting on cash piles and invest in their business’s growth.
In addition, the September and October export figures have continued to look strong, boosting the share price of companies in that sector.
Other positive signs have come from companies in the food sector that are raising prices for the first time in years. Probiotic drink Yakult, for example, is about to raise its price for the first time in 22 years.
Economic boosts are also expected ahead of the Olympic Games in 2020, with construction, infrastructure, and tourism expected to see a spike in value.
There are some concerns to be aware of however. Many Japanese companies are still not “shareholder friendly”, according to Sasaki, and more work is needed to boost shareholder and corporate governance levels.
“Prime Minister Abe had said at a conference in New York earlier this year that this would be a key item of his growth strategy,” Sasaki added.
Sasaki is also currently underweight in pharmaceuticals and construction, as he’s mindful of an earlier rally now petering out, plus the planned tax hike scheduled to take place in 2014.
Consultants are starting to believe the Japanese recovery story, although it is unlikely we’ll see investors dramatically changing their holdings any time soon.
Tapan Datta, Aon Hewitt’s global head of asset allocation, told aiCIO he expected Japanese equities to outperform other major markets, particularly the US, and that an upper single digit estimate for Japanese returns did not look unreasonable.
“Japanese equity valuations, even after the large run up this year, still offer upside,” he said. “Japanese equities have traditionally been diversifying (lower correlations with global markets than other pairs of markets) and given our views on them, we expect Japanese equities to be at least market weight in a global equity portfolio.
“Institutional portfolio positions will have been rising, but mainly because managers have been raising Japanese allocations (albeit from very underweight levels in the last couple of years). But there are limited signs of large new allocations being made to Japanese equities on a standalone basis.”
The risks to be aware of in Datta’s view were the still-fragile consumer and business confidence, and the prospect of real wages not rising.
“The key risk is that the battle against deflation is not won. Ramping up monetary easing is a good first step to achieve this, but it is far from enough,” he continued.
“It’s also important that Japan’s chronically low corporate profitability rises for the good of the equity market.”
Steps to curb the rise in the public debt, which currently stands at 214% as a percentage of GDP, are also urgent, Datta added. Were it not for low interest rates and the ability of the government to draw on large domestic savings, the current level would be unsustainable.
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