Japanese equity market: low valuation, trade conflict an obstacle

Ever since 2013, Japan has been in the grip of “Abenomics”, a concerted effort to end the stagnation of the economy (which dates back decades) through a combination of reforms and fiscal and monetary stimuli. Six years on, a number of successes are apparent. Nominal gross domestic product (GDP) has risen, while the labour market currently has virtually no slack, with the unemployment rate standing at 2.5%. On the negative side, the government debt mountain has risen continuously and now amounts to almost 240% of annual economic output. In other words, Japan’s freedom of manoeuvre to deliver further fiscal policy stimuli is becoming increasingly limited. In the short term, Japanese inflation remains stubbornly low and the country’s economic growth remains dependent on the global environment. Against this challenging backdrop, real Japanese GDP actually declined in two of the four quarters of 2018. Although growth in the first quarter of 2019 surprised on the positive side, there are hardly any grounds for euphoria looking ahead. As one of the world’s major exporters, Japan – just like Germany – is heavily exposed to the risk posed by the ongoing trade tensions between the US and China. Hopes for an increase in government tax receipts are dwindling – which means the increase in VAT originally planned for October may now be in the balance.

Looking at the big picture from a corporate perspective, it is apparent that Japan has enjoyed not only an improvement in profitability in recent years – as measured through metrics such as return on equity and profit margins – but also an improvement in the image of its companies: This is attributable to numerous optimizations on the operating side, but also to reforms in the area of corporate governance (particularly in connection with family clans and conglomerates) and the further opening-up of Japan’s financial market (including a higher degree of coverage by financial analysts and the publication of English-language company reports). The surplus capital of Japanese companies, which remains unusually high in an international comparison, is increasingly being returned to shareholders in the form of dividends and share buybacks, or is being used for mergers and acquisitions. Furthermore, undervalued subsidiaries are being bought up by the conglomerates. Given the history of recent decades, these actions on the part of Japanese companies should not be taken for granted. In addition, the very accommodating policy of the Bank of Japan is supporting large companies.

Thanks to a generally stable domestic economy and still robust demand from abroad, earnings development in the Japanese equity market should remain robust. The earnings of the largest Japanese companies should rise by more than 6% both this year and in 2020. This would be a less dynamic growth figure than is currently expected in Europe, e.g. in the case of the DAX and Euro-Stoxx 50 companies.

Valuations of Japanese equities have become more attractive. At a price/earnings ratio of 12.7x, the Topix is currently trading at a significant discount to its long-term average (just under 15x). At 2.6%, the dividend yield of the Topix is also higher than the average of recent years. We consider these valuation ratios to be attractive. The Japanese equity market is currently the ninth most attractive market on the list of 46 country markets scrutinized by us on a monthly basis – among developed markets it is the third most attractive after South Korea and Austria.

Outlook: As was the case in 2018 (and similarly to the DAX), the high degree of openness of listed companies and the nation’s “sandwich position” between China and the US pose a risk to the earnings development of major Japanese companies. By contrast, if the conflict were to defuse somewhat and China were to show greater economic momentum in the second half of the year, Japanese companies are likely to benefit. As things stand, however, it is unclear whether negotiations between Washington and Beijing will actually deliver any positive results. If the Japanese government were to abandon the VAT increase scheduled for October, this would act as an additional price driver.

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