By Marlies van Boven and Hiromichi Tamura, Global Investment Research
The Japanese stock market has pulled out of its long-running losing streak this year, holding up far better than most of its developed peers amid the fierce global sell-off this spring and joining the UK in the outperformers’ ranks for the past 12 months. This turnaround in fortunes begs the question: Can it persist?
Regional Index returns relative to FTSE All-World ex Local Market (TR, LC)
Source: FTSE Russell. Data through May 31, 2022. Past performance is no guarantee to future results. Please see the end for important disclosures.
Weaker yen loses its power over export-driven Japanese stocks
One of the hottest topics across financial markets this year has been the historic depreciation of the yen against the dollar, which bottomed at 135.20 on June 13, the weakest level since October 1998. This trend has been underpinned by the starkly divergent paths between the two countries’ monetary policies, with the US Federal Reserve aggressively tightening to fight inflation while the Bank of Japan remains ultra-accommodative to stimulate economic growth. As shown below, yen weakness has closely tracked the widening gap between Japanese and US 10-year government bond yields.
US/Japan 10-year government bond yield gap (%) and USD/Japanese yen exchange rate (RHS)
Source: FTSE Russell / Refinitiv. Data through June 14, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Historically, a weaker yen has been a major driver of the export-powered Japanese economy and, thus, its stock market. But that relationship has broken down recently: the 24-month-rolling correlation between moves in the USD/yen exchange rate and Japanese equities has been in a sharp downtrend since the outbreak of Covid-19, then turned negative in September 2021. What has caused this sharp departure from history?
24-month-rolling correlations – FTSE Japan Index (LC %) to US dollar/Japanese yen exchange rate
Source: FTSE Russell. Data through May 31, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The Ukraine war and the spike in commodity prices
One key explanation for this shift is rooted in the war between Russia and Ukraine, which intensified already acute upward pressures on key commodity prices. As depicted below, Japanese export prices have significantly lagged the soaring costs of raw material and energy imports, squeezing profit margins. Japan’s main trading partner is China (accounting for 24% of its imports and 22% of all exports), underscoring Japan’s vulnerability to the ongoing supply-chain constraints and slowing economic growth stemming from China’s zero-Covid and lockdown policies.
Japan CPI and Import and Export Price Indexes
Source: FTSE Russell / Refinitiv. Data through May 31, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Strong corporate earnings outlook …
But there are other forces working in favor of Japanese stocks. Forecasts look for a far speedier EPS recovery in the year ahead for Japan than for Europe and the UK, and have caught up with those expected for the US. As discussed above, the yen's depreciation may not be as positive a factor for Japanese equities as it has been historically. However, according to a Bloomberg survey in late May, listed companies in Japan have assumed an average foreign exchange rate of 120 yen to the US dollar in their earnings guidance, suggesting some upside potential to earnings forecasts if the yen remains weaker than those corporate targets.
Consensus (I/B/E/S) 12-month forward EPS forecasts (rebased)
Source: FTSE Russell / Refinitiv. Data through June 14, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
… but no valuation re-rating
Notably, at 12.9 times 12-month-forward consensus EPS forecasts, investors appear to be overlooking Japan’s strong earnings growth potential, particularly relative to that of the US.
Price/12-month-forward consensus EPS forecasts
Source: FTSE Russell / Refinitiv. Data through June 14, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Corporate governance reforms a potential catalyst
So what would it take for Japanese equities to continue to outperform? A major reason cited for why Japanese stocks have been undervalued for so long is their low capital efficiency: the country’s companies have historically put far more focus on maintaining market share and employment than on maximizing shareholder returns. As measured by consensus 12-forward returns on equity (ROE), capital efficiency in Japan remains dramatically below that of its developed-market counterparts.
Consensus (I/B/E/S) 12-month forward ROE forecasts
Source: FTSE Russell / Refinitiv. Data through June 14, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
But changes are afoot. Under the government’s Corporate Governance Code, which has been in effect since June 2015, Japanese companies are working to improve productivity and profitability by focusing more on cost of capital and improving corporate governance. In April 2022, the Tokyo Stock Exchange reorganized its investor/company engagement and implementation guidelines into three categories of companies: Prime, Standard and Growth.
To maintain their top-tier Prime listing, companies will be required to have at least one-third of their boards comprised of independent outside directors, and to minimize cross-shareholdings and policy holdings between companies. If such reforms result in higher ROEs, Japanese equities are likely to benefit, as suggested by the strong historical relationship between reported ROE and P/E multiples across developed markets, illustrated below.
Relationship between latest reported ROE (%) and P/E multiples as of June 14, 2022
Source: FTSE Russell / Refinitiv / Worldscope. Data through June 14, 2022. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
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