WisdomTree writes on achieving smart exposure to Japan
Nizam Hamid, ETF Strategist at WisdomTree in Europe, has written a note on the Japanese market, commenting that in a time of low valuations, earnings growth and a weaker Yen, what’s the smart approach to Japanese equity exposure?
After US equities, Japanese equities are the second largest country weighting in the MSCI World Index, at close to 9 per cent as of the end of October 2017. As such, Japan is an important allocation for many investors. However, the country has unique economic and equity market attributes, and therefore it’s paramount that investors find an appropriate investment solution, Hamid writes.
Abenomics and structural reforms are driving Japan’s self-sustaining domestic demand-led up-cycle. For many years investors shied away from Japanese equities because of long-term structural weakness in the economy, deflationary pressures, weak GDP growth and a lacklustre approach to corporate governance.
The election of Shinzo Abe at the end of 2012 created a new dynamic of monetary easing, fiscal stimulus and structural reforms. Abenomics has been at the heart of the investment thesis for Japanese equities and the recent election results seal Abe’s hold on power in the medium term.
Structural reform remains one of the key pillars to change. Recent improvements are positive, including dramatic shifts in monetary policy, to negative rates, and a target of a zero per cent yield for 10-year government bonds. The most recent April-June 2017 GDP report suggests that the Japanese economy has entered a sweet spot, with growth accelerating and broadening into all components of domestic demand. The report confirms our view that Japan has entered a self-sustaining domestic demand-led up-cycle.
Japan’s economy continues to respond positively to structural reform and change. For example, wage and income dynamics have experienced an upturn, with the absolute level of workers’ compensation rising by 2.6 per cent in April-June. This has pushed absolute compensation to levels not seen for over 17 years, back in 1998/1999. More importantly this up-trend is structural, not cyclical. At the same time, Japan’s demographics, including a shortage of labour, are forcing a structural shift from part-time to full-time employment and placing steady upward pressure on wages and income. We expect this structural improvement in employment quality to create a strong foundation for rising household spending.
Private sector capital expenditure recently registered its eighth-consecutive growth quarter. Meanwhile, companies are benefiting from record-low interest rates and record-high cash balances which will strengthen their ability to raise investment. In our view, Japan’s business investment cycle has further to run and the visibility of the capital expenditure cycle suggests it is poised to become a key leading indicator of the underlying strength of the economy. This leads us to believe that Japan’s capital goods sector is poised for both domestic- and export-led growth.
Low valuations, strong earnings growth and a weaker Yen
We believe that positive earnings momentum predicated on a pickup in top-line sales growth and a weaker currency can deliver substantial earnings growth in the coming year. The broad equity market, as represented by TOPIX, is trading at the lower end of its valuation range in terms of both historic and prospective PE ratios. In the current fiscal year, to March 2018, we expect earnings growth of approximately 25 per cent, based on sales growth of close to 4 per cent and an exchange rate of around Y115.
At the heart of the Japanese equity story is the performance of the Yen. In early Q4 2016, having languished at levels close to Y100 vs the US Dollar, the rapid appreciation of the dollar in a post-election environment saw the exchange rate weaken to over Y118. The strength of the dollar then unwound over the course of the year, with the Yen dipping below Y110. However, following Abe’s recent strength in the elections the Yen has fallen to around Y115.
The main impact of the weaker Yen, which is a core part of the Bank of Japan's policy aims, is to reinvigorate inflation through higher import prices. This should help to stimulate demand, and provide a boost to exporters and overseas sales and profits. Whilst domestic recovery is a long-term aim, we believe a weaker Yen will have a more meaningful and direct impact on export-oriented companies. This has been quick to reveal itself in the outperformance of the export-tilted WisdomTree Japan Equity Index compared to other Japanese equity benchmarks such as the MSCI Japan Index or the JPX Nikkei 400, which are all measured with a US Dollar hedge.
Over time it is also evident that the WisdomTree Japan Equity Index is typically more sensitive to movements in the exchange rate.
Export sectors as a source of alpha
Our unique export-oriented index focuses on dividend-paying stocks and requires companies to generate at least 20 per cent of their revenue overseas. This provides investors with a differentiated sector and company composition. Our methodology tends to produce an index that has substantial deviations in sector weights compared to benchmarks such as the MSCI Japan. These sector over and underweights can deliver significant contributions to performance, as shown in the table below.
The current largest overweight sector within our index is Consumer Discretionary with a weight close to 24.4 per cent. This is 4.0 per cent overweight relative to the MSCI Japan Index, although this has had a negative impact on performance in the 12 months to November 2017. Industrials, where our index is overweight by almost 2.0 per cent compared to the MSCI Japan, has delivered over half the outperformance of the past year. The main areas where our index is substantially underweight are the domestically-oriented Telecommunications Services, Energy, Utilities and Real Estate sectors. On a combined basis, our index is around 11.5 per cent points underweight relative to the MSCI Japan, and this has delivered a 2.84 per cent outperformance over the past year. The WisdomTree Japan Equity Index also outperformed the JPX Nikkei 400 Index, which has a focus on quality factors such as return on equity and operating profits, as well as corporate governance measures.