Investment executives have ascribed a “constructive” outlook for Japanese equities amid increased investor unease following the market’s double-digit declines at the start of August.
Spurred by macro and systematic trades amid concerns of a US recession, the Bank of Japan’s (BOJ) surprise decision to lift interest rates, and a rapid appreciation of the yen, Japanese stocks experienced their worst trading day in almost four decades on 5 August, with Japan’s Nikkei 225 stock index losing more than 12 per cent in one day.
The market cumulatively shed around US$1.1 trillion in a three-day sell-off, as investors began to fear that the yen’s rapid rise would dampen the earnings of Japan’s export-oriented companies.
According to the latest Bank of America Global Fund Manager Survey, allocations to Japanese equities experienced their largest one-month drop since April 2016, declining from net 7 per cent overweight to net 9 per cent underweight.
These allocations are now at their lowest point since May 2023.
Analysts at Templeton Global Equity Group, part of Franklin Templeton, believe this market reaction is “extreme”.
“Unless one thinks the US economy is in for a hard landing, the level of the sell-off in Japanese equities appears unjustified,” they said in a market note.
“We expect market volatility to persist in the short run amid the ongoing debate surrounding the US outlook and uncertainties driven by the unwinding of the yen carry trade. However, our base-case view is still a soft landing for the US economy. Against this backdrop, Japanese equities should continue to deliver long-term value, especially for fundamental stock pickers.”
The analysts opined that the fundamental picture for this market remains unchanged, with Japan’s structural return on equity (ROE) improvement story still intact.
Additionally, the economy is normalising after three decades of deflation, they pointed out, and corporate reforms have gone mainstream.
“These unique opportunities are under-represented at the stock index level,” the analysts said, alongside indicating that they will jump on the “mispricing” arising from the volatility.
Speaking to InvestorDaily, Betashares investment strategist Hugh Lam also observed the sharp sell-off earlier this month has “caused a lot of volatility and uncertainty about the future trajectory of Japanese equities”. Despite this, he believes the overall outlook remains positive in the middle to long term.
He, too, cited a number of factors driving his optimism, including shareholder-friendly reforms in buybacks and dividend payouts; strong corporate balance sheets demonstrating low debt and high levels of cash holdings; and attractive valuations compared to the US.
“Japanese equities, relative to the US, are attractively priced,” he told InvestorDaily.
“They’re trading at around 15x earnings, which is considerably less than the US, and when you account for the earnings growth they’re expected to generate over the next year – around 10 per cent – it’s actually quite a good pay-off.”
Also reflecting on the sell-off, Daniel Hurley, global equities portfolio specialist at T. Rowe Price, described the correction as “excessive”.
In a market note, he said this could instead be an opportune time to “selectively add” to Japan equities, especially names with less exposure to the US economy and yen strength.
“Looking ahead, domestically, we are closely monitoring inflation, especially wage inflation numbers, as these will be the key determinant for the Bank of Japan to confirm that the economy is unshackled from 30 years without inflation,” Hurley explained.
“Broader domestic data appears healthy in terms of GDP growth and consumption [and] the stronger yen should offer further relief for domestic consumers as it reduces food and energy import costs.”
Cause for caution
However, Joe Unwin, head of portfolio management at Apostle Funds Management, offered a slightly different perspective, noting that the sell-off “doesn’t seem that excessive” when compared to the recent Japanese yen rally.
The Japanese currency rallied 8 per cent on the dollar in three weeks to 1 August to 149.2 a dollar, threatening to unwind the carry trade investment strategy. Currently, the yen sits at 147.2 a dollar.
“That’s a significant drop in earnings expectations that justifies the sell-off in Japanese stocks,” Unwin told InvestorDaily.
“Investors need to keep in mind that Japan had been one of the best-performing equity markets over the past 6-12 months prior to the sell-off, so there was plenty of room to fall.”
In light of this, he urged caution with respect to the Japanese market while the yen rally maintains momentum.
“Major financial institutions have suggested that the unwinding of the yen carry trade is still in motion, which suggests that the yen could continue to be supported by excessive buying volume from traders,” he said.
“Additionally, the BOJ has made ongoing attempts to prop up the value of the yen, which suggests that downside could be limited by regulatory intervention.”
According to Unwin, the strengthening of the yen against the US dollar will prove to be a key headwind in the future.
Though the yen has rallied around 10 per cent over the last month, it started that rally from a historically low level, Unwin pointed out, and remains 30 per cent lower than it was three years ago.
“So, there is plenty of room on the upside,” he said.
“Over the last 25 years, Japanese stocks have underperformed US stocks by ~7 per cent per annum on average during periods when the yen has strengthened versus the US dollar.”
