Spotlight on Japan

Charlie Parker
Charlie Parker
17-12-2019

Japanese equities have lagged global equities for 29 years; something that has coincided with a falling bond yield. The most recent low occurred over the summer and Japanese equities have started to pick up. The market breadth readings are the strongest since 2016 and we are seeing the banks, brokers and cyclicals break higher. The market signals have got our attention, and the next step is to dig into the detail. 

Between 1970 and 1990, Japanese equities were the superstars, along with Korea and Taiwan. Valuations went sky high only to peak in 1990. A drawn out two-decade derating followed, and it wasn’t until the financial crisis in 2008, that you could describe Japanese equities as cheap. And even then, they only paid a 3% dividend yield. 

This derating and underperformance coincided with a falling JGB yield. Japanese bond yields were the first to fall into negative territory in 2016. JGBs then led global bond yields lower, before passing the baton to European bonds earlier this year. Having previously been the leader in the race to negative yields, JGBs have turned the corner over the summer. Just as falling yield led to Japanese equity underperformance, it stands to reason that rising yields will lead to outperformance. If this sell off in bonds continues, Japanese equities could have a long way to run.  

One issue that had dragged on has been a weak economy held back by a weak banking sector and an ageing population. Their problems have certainly slowed growth, but perhaps not as much as widely thought. Unemployment is just 2.3% and there are 1.6 jobs for every applicant; an even higher number than in 1990. Office space is also tight with the lowest vacancy rate on record. Bank deposits and lending are growing, and the economic surprise index is buoyant. 

The valuation is also attractive. Japan has never been a high dividend yield market, but it now pays 2.4%; a level last seen in 2012, and only ever beaten at the depths of the credit crisis. Earnings are expected to grow by 7% a year for the next two years and the market trades at an undemanding 12 years’ earnings. 

That valuation works for us, but better still is positioning. Foreign investors are significantly underweight Japanese equities as they have been selling them down for the past four years. As Japan starts to perform, those investors will have little choice but to increase exposure; something that will accelerate if JGB yields keep on rising. 

There have been many false dawns for Japanese equities. But when the banks, steel and shipping stocks lead the way, you can’t ignore the potential for a value rally. They have been fabulous hosts of the World Cup and it doesn’t end there. Next year they host the Olympics and all eyes will be on Japan.

Equities 

In sterling terms, all equity markets have been in positive territory over the last 12 months, so what can we expect from here? International weakness triggering a broad manufacturing slowdown? A potentially overconfident consumer and a Federal Reserve caught up in a brief interest-rate cutting cycle, regardless of steady GDP growth? And, of course, an impeachment inquiry. As we said last month, does this sound like a recipe for a strong fourth-quarter rally? Whilst history never repeats exactly, those are the same circumstances that we faced in 1998 and the markets then enjoyed a further 2 year extension of the bull market into the peak in 2000.

For most of this year investors have feared deflation and that has driven bond yields to the lowest levels we have ever seen. Yet over the past two months, this has been turned on its head. Bond yields and inflation expectation are now rising, which favours value assets over growth. In addition, bond yields are rising faster than inflation which mean that real yields are rising. This is most pronounced in the UK where real rates have risen from -3% to -2.4%, thus boosting the pound in the process. 

Higher US inflation would be very painful for the bond market, yet not necessarily for the stock market. After all, when Trump won the election, bond yields soared along with US equities. It would be no friend of 2019’s winners such as quality companies with bond-like characteristics, nor gold. Yet it could see the economically and value sensitive sectors shine.

The common narrative that everyone believes that everyone else believes that the central banks can continue to underpin the markets is still in play but is beginning to attract some negative press, not least of all from the US President. With an election next year, he will keep up the pressure on the Fed and this week we have seen another cut in rates. Powell reiterated that they will be watching in coming data to determine future policy and the unspoken suggestion is that any significant correction in markets will be met with further quantitative easing.

Bonds

Global sovereign debt yields are still close to all time lows and in Europe and Japan nominal yields have been negative for some time. In the US and UK real yields are also negative. The spread between sovereign and corporate debt, both investment grade and high yield, is not sufficiently wide to compensate investors for the additional risk that they are taking. Liquidity is also another consideration in bond world which is a further detraction. Over 60% of global corporate debt is now just one rating notch above non-investment grade which we used to call “junk”.

Alternatives 

This is a very diverse sector and we view some of these assets as insurance policies against central bank monetary mistakes and to provide a source of non-correlated assets to bring better diversification to portfolios; we include here exposure to precious metals and other alternative investments, infrastructure for example. As with conventional insurance policies, there is always an upfront cost with the pay-out coming later but providing comfort against the possibility of rising volatility in the meantime. Over the last 6 months we have started to see the protective element of these strategies beginning to kick in. Gold in particular has done very well but with real yields rising again we are anticipating a pull back for the time being; potential sterling strength is a negative too.

UK

The Brexit “party” has yet again been postponed and we now face a general election on what will probably be a cold and damp Thursday in December. The outcome is unclear, but a coalition of Tory and Brexit Party resources would pave the way for ratification of a deal which will be positive for equities and sterling. A Labour, LibDem, SNP coalition is too frightening to contemplate, but we will be watching the polls closely although ever minded of their fallibility. Business confidence, which to a great extent has been driven by the uncertainties surrounding Brexit, is an important indicator to watch

Sterling has found strong support at $1.20 and rallied up to $1.30 in short order. Anything approaching an agreed deal would see a further bounce from these levels. The stock market too; although sterling strength makes the UK less attractive for overseas buyers, all of whom are underweight the UK. Merger and acquisition activity would also pick up. On a valuation basis the UK is at its cheapest relative to global markets since the 1990s.

US

The trade war with China has undoubtedly helped the global economy into a downturn especially in Europe, Asia and Japan. Because its service and consumer sectors dwarf manufacturing in their contribution to GDP the US is, thus far, the least affected, which may account for the high levels of consumer confidence and the low levels of unemployment. However, both data series always reach such extreme levels as a precursor to a recessionary phase, something beyond the ken of a twittering president.

But could this time be different? If the Fed supply large quantities of QE one effect will be a weaker dollar which will make imports more expensive and create inflationary pressures, which, in turn, should lead to higher wage costs in the economy and with it higher spending power, but at the cost of lower profit margins. Lower rates will help cushion the blow as will QE if it does reach all parts of the economy and not just the financial sector. A quick resolution to the trade wars would do it too, but that looks unlikely. We suspect the Fed will not use QE until forced to by a market dislocation which could well arrive via the bond market.

Technically the market is still in a rising trend and has just made a new all-time high. The market level is some way above the long term mean and it may take a breather here, but it would take a fall below 2700 to mark a change into bear market territory. 

Europe

The European economy has weakened rapidly, led by Germany, unarguably the powerhouse of the EU. Much of this has been triggered by the US / China trade wars, but we mustn’t forget that Trump has his eyes on Europe too, which won’t help either. There continues to be concerns over the European banking system. Unlike in the US, the European banks did not recapitalise after the great financial crisis. 

Christine Lagarde now takes up the reins at the ECB. She will need to use all her political skills to persuade the other members that further rate cuts and QE are necessary although how effective that plan will be is becoming ever more doubtful. The central banks are running out of ammunition and Draghi again commented at his final press conference that accommodative fiscal action will be needed requiring something of a volte face from the EU Commission and the northern European economies. Let us see how that turns out.

The European indices have collectively failed to regain the pre financial crisis peaks and have been range-bound ever since. However, we are seeing an attempted break out to the upside of a range that has been in force for the whole of 2019 and is accompanied by a rising long term mean. The future of the European project is at a critical stage and it remains to be seen whether investors are keen to take on the risk despite the relative weakness or not.

 Japan

On a yield of 2.4%; a level last seen in 2012, with earnings are expected to grow by 7% a year for the next two years and trading on 12 years’ earnings the Japanese market represents very good value. Confidence and manufacturing surveys have been trading sideways since 2010 and although the series have been deterioration of late they are in better shape than the major western economies.

The market is making progress above the psychologically important 21000 level and a break above 24000 would confirm our suspicions that this market is due for a significant rerating.

 Asia Pacific & Emerging Markets

The Asian and Emerging economies will be the main contributors to market returns in the years to come. A burgeoning middle class with access to cheap borrowing will be the drivers. They have been and will continue to be far more volatile than their western counterparts; currency issues – dollar strength in the main and corporate governance will exacerbate this trend, but higher volatility generally comes with positive outcomes; higher prices in the long term. 

The question is whether the institutional buyer, vital for long term traction in any market, is being put off by the lack of concern many emerging market sovereigns have regarding property rights. A surprising number have been burned in Argentina, including the IMF whose bail out came with the wrong set of strings attached. Investing in these markets requires an idiosyncratic outlook; passive investing won’t help you here.

So far this year dollar strength (the green line on the chart) has been a headwind. If we do indeed see dollar weakness, then that would provide some impetus, as we saw between 2002 and 2008, but it won’t necessarily overcome the effects of a global economic slowdown and a protracted trade war in the short term.

Oil

$50 is still providing support for crude and we are back in the $50-$60 trading range. A break either way will give us a better clue to the direction of travel. Currently the seesaw between a slowing global economy and reduction in supply if Middle East tensions escalate, is in the balance. Again, a depreciating dollar would be a positive for the oil price again as evidenced by the period from 2002 to 2008.

Gold 

Gold has enjoyed an impressive rally and the long base formation since 2013 has resolved to the upside.

The rally however has attracted much speculative attention but with a rising real yields the run looks to be over and a correction to the long term mean at around $1400 is on the cards. Sterling strength is also a detraction for UK investors. When inflation starts to pick up so too will the prospects for gold.

Bonds

With bond yields at all time lows, significant sovereign debt issuance in the pipeline and narrow spreads on corporate and high yield debt the bond complex is not providing enough return for the risks taken. The conundrum for the Fed is that the government just cannot afford to pay significantly higher rates on its debt. We suspect they will maintain a cap on Treasury yields much as they have in Japan and let equities and inflation rip. 

This will maintain US sovereign debt as a short duration risk off asset, but corporate and high yield spreads are likely to rise dramatically under such a scenario, acknowledging that current bond rates do not provide sufficient risk-adjusted return. To reiterate our comment las month, “the bond market might just be the most dangerous safe haven the financial system has ever created.”

Technically we are at strong support on a yield basis and well below the trend mean so we expect to see some lower prices for Treasuries in the short term, which means higher yields.

Summary

Central bank rhetoric has changed yet again, and the Fed have cut rates for the first time in 10 years and ended quantitative tightening. No sign of quantitative easing yet but we suspect the markets may force the Fed’s hand

  • Government bonds are very expensive – but the flight to quality aspect has not yet disappeared, certainly for short duration assets.
  • Spreads on corporate bonds, both investment grade and high yield have begun to rise, but still don’t provide sufficient return for the risk taken. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing. “Liquidity is a state of mind”
  • Western equity markets are long overdue a significant correction; we suspect this is imminent and we wait to see the central bank response.
  • Property is attractive, as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise, but long term infrastructure is another potential inflation hedge at some stage.
  • The ECB has changed course with the TLTRO scheme. Christine Lagarde has taken over from Mario Draghi and is firmly in the dovish camp, so expect continuing accommodative policies. The Nikkei index is not expensive; domestic issues are preferred. Emerging and Asia Pacific markets are not overly expensive either as a selective long-term position, but they will nevertheless continue to be volatile and affected by dollar machinations and currency devaluations, trade wars and Chinese economic weakness as we are seeing currently
  • Gold is an insurance policy against central bank monetary policy mistakes, but a resumption of higher real yields means a corrective phase is in the offing. 
  • Commodities have potentially reached a bottom relative to equity markets, but no upturn yet. Oil has fallen significantly; bearish for the global economy? Or do we get a rebound on Fed QE and dollar weakness?
  • Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. As ever, we observe closely for signs of success… or failure