Originally published by BetaShares
Although the Japanese economy has long been considered sluggish and blighted by deflation, it may surprise some investors to know that economic growth and corporate earnings growth in recent times have been impressively strong. What’s more, this improvement has been only partly rewarded by rising equity prices, leaving Japanese equities relatively cheap by global standards.
Japan: A source of surprising strength
Due to population ageing, low immigration and a lack of competition-enhancing reforms in many sectors, the Japanese economy has long suffered from relatively weak economic growth by global standards. It has also long struggled with bouts of deflation which many Japanese policy makers perceive has further held back the economy.
Yet despite this perception, the Japanese economy grew by a better-than-expected 1% in the June quarter (4% annualised), after also impressive 0.4% (1.5% annualised) growth in the March quarter.
As seen in the chart below, the economy has expanded for six consecutive quarters – it’s best result in just over a decade. And while exports and another fiscal stimulus program were the main early contributors to the current period of growth, private consumption and business investment picked up in the June quarter. With labour markets tight and rising female work-force participation, there appears promising scope for further gains in labour income to kick-start a self-reinforcing cycle of better domestic demand.
Source: Bloomberg
Corporate earnings have also improved
But it’s not just the GDP numbers that have been impressive. Japanese corporate earnings have also shown admirable growth for a long period. Indeed, as seen in the chart below, growth in “forward” earnings for the companies within Japan’s Nikkei 225 index have in fact matched pace with that of US companies in the S&P 500 Index over the past decade or so, and have shown particularly strong growth in the past year. Over the year to end-July, for example, Japanese forward earnings grew by 17.6%, compared to growth of 9.6% in the US.
As evident, while Australian forward earnings enjoyed a spurt of growth over the past year due to the rebound in iron-ore prices, they have generally been much weaker than in either Japan or the US since the peak in commodity prices back in 2011.
Valuations relatively attractive
What about valuations? Due to Japan’s generally much lower level of interest rates, equity price-to-earnings (PE) valuations have usually traded at a premium to the average among global stocks. Indeed, the average Japanese PE premium over that of the World MSCI Index since 2003 has been around 20%, compared to a current premium of only around 4%. As seen in the chart below, Japan’s price-to-forward earnings (forward PE) ratio is currently broadly in line with its long-run average of around 16.5, despite the sharp decline in bond yields in recent years. By contrast, the MSCI all-country World Equity Index (and America’s S&P 500) are trading notably above their longer-run average.
A weaker yen would add to the appeal of Japanese equities
Note, moreover, that although Japanese equities outperformed global stocks in the second half of 2016, relative (currency hedged) performance has been held back so far in 2017 by renewed strength in the yen versus the US dollar. Given that the Bank of Japan has intimated it is far less likely to tighten policy over the coming year than either the US Federal Reserve or even the European Central Bank (due to stubbornly low inflation), however, Yen weakness could resume over the coming year. This would certainly be the wish of the Bank of Japan.
As seen in the chart below, Japanese stocks have tended to perform particularly well during periods of yen weakness.
