A Winning Holiday-Shortened Week
What happened last week?
Last week, the S&P 500, Dow and Nasdaq gained 1.95%, 0.66% and 3.50%, respectively, in a 4th of July holiday-shortened week. The US economy added 206K jobs in June, but the unemployment rate rose to 4.1%, its highest level since November 2021.
3 Things to Know
Positive Outlook for Japan
The MSCI Japan index reached a peak on March 22 of this year and has been in a 7% trading range since then. But on July 1st, the index made a new high, potentially signaling a new breakout.
Meanwhile, index earnings per share estimates have been revised up by 7% since March. This pattern of market consolidation and upward EPS revision was also visible in the second half of 2023, which was followed by a period of breakout performance.
This took the forward PE ratio down to 16x, which is higher than the 10-year average of 14.6x. But given potentially higher return on equity (ROE), we believe that the valuations should also rise above the historical average.
Among the MSCI Japan sectors, Energy, Financials, Industrials and Telecom had seen the largest upward earnings per share (EPS) revisions during the consolidation period. IT, Consumer Discretionary, Materials and Telecom have seen the greatest gap between stock performance and earnings revisions. These are likely areas that may see a catch up in the next potential stage of a reform-driven rally.
The BoJ Is Set to Tighten Policy
The last time the yen exceeded 161 per USD was just a year after the 1985 Plaza Accord when developed nations coordinated to sell US dollar (USD) and buy yen. This time, Japan's Finance Minister Suzuki once again declared his heightened concern about the impact of rapid and one-sided currency moves and the need to watch FX developments with a high sense of urgency, sparking expectations for FX intervention.
BOJ Governor Ueda does not yet believe Japan is on a path towards sustainable demand-led inflation and cites the lack of pass-throughs of higher labor costs to service prices as the reason for the delay in raising rates. However, Japan's longer term inflation expectations continue to rise and the longer the BOJ delays raising rates, the more tightening it may have to do later. Caught in between these constraints, rates markets currently expect the next 10bp hike in September, and 62bps of rate hikes over the next two years.
Bullish Trend May Resume
The rally in Japanese equities over the past 15 months took place in two main stages, each a result of progress in corporate governance reforms, rather than yen movements. The first stage started in March 2023 when the initial Tokyo Stock Exchange (TSE) reforms targeted companies with a price/book ratio of below 1.
This led to a wave of dividend and buyback announcements. The second stage started in at the beginning of 2024 on the wave of corporates announcing plans to unwind cross shareholdings, and to invest the dormant capital freed up from the transactions.
These rallies took place partly because the corporate reforms moved forward to a next stage.
Foreign investor inflows have slowed in June but are likely to resume as more investors aim to capture corporate reforms and to take advantage of the cheap yen. In the first half of 2024, $40bn of inflows came to Japanese equities, far more than the $24bn in the entire 2023.
Still, more could still come, as cumulative inflows remain well below the level seen during the peak of Abenomics in 2015.
It seems ironic that so many investors (albeit many from Asia), are concerned that Japan's equity markets could be peaking when US equities continue to power on to new all-time highs at a significantly higher valuation.
Long gone are the days when Japan traded at 80X peak earnings and accounted for 45% of world equity market cap in 1989. Today, Japan shares represent a potential diversification opportunity with growth potential and value for suitable global investor portfolios.
We believe Japan is putting its long deflationary policies in the rear-view mirror. We see building and lasting momentum for corporate reforms to reward shareholders. Many of its firms are crucial to global supply chains.
Volatility in Japan's currency may unsettle global investors in the year ahead. However, we see this culminating in the direction of a rebounding yen.
See our weekly CIO Strategy Bulletin for more details