Asset Allocator: June 2015- Find Surging Markets

In this week’s Asset Allocator, David Stevenson turns his attention to the Japanese Stock market and its performance over the past year where the enormous growth in corporate profits is mainly due to maintaining evidence of reform at a national level as well as to the massive cultural shift amongst Japanese corporations.

The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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 ASSET ALLOCATOR: JUNE 2015

16/06/15- Finding Surging Markets 

 

 Japanese equity markets are on a tear again. After a sticky end to 2014 – prompted in part by domestic political uncertainty – the benchmark Nikkei 225 has started to surge ahead again. 

 The first chart below shows the performance of the Nikkei over the last two years – the Japanese index is represented by the black line while the red line is the FTSE 100 UK index. 

 Chart - Nikkei 225 Outperformance over last two years

 

 The next chart shows this out performance gap opening up over the last six months, with the Nikkei 225 index pushing ahead since January.

 Chart - Nikkei 225 Outperformance over the last six months 

 

 The table below - from S&P Dow Jones indices - puts some hard numbers to this outperformance. The table uses the broader composite S&P DJ indices (the BMI family of indices) and is based on data through to June 1st 2015. 

It shows that over the year to date Japanese equities pushed ahead by 14% against just 4.53% for developed world equities. Over the one year to June 1st, Japanese equities were up 13.64% against a 5.84% decline for UK equities. 

 

 Will this significant out performance continue throughout the remainder of 2015 and what’s driving share price appreciation? In this short article I’ll argue that investors should probably consider being overweight Japanese equities largely because I suspect that the rally is built upon two fairly robust foundations – continuing evidence of reform at the national level and a potential culture shift amongst Japanese corporations.

 Crucially both of these trends are helping to reinforce strong corporate profits.

 

  The political driver for reform is fairly obvious – Prime Minister Abe’s three arrows of reform and change and the need to arrest many decades of relative economic decline.

 As analysts at Societe Generale note there have been numerous bills submitted during current session of diet (the local parliament) and in fact “PM Abe is committed to passing as many bills as possible to further the progress of Abenomics, most immediately in the fields of agriculture, labour, and healthcare. As of end of April, 71 items of legislation had been submitted to the current diet, and seven of them have already been passed…… Abenomics aims to restructure fiscal policy not by depending on fiscal consolidation, including tax hikes, as the main source of revenue but rather by exiting deflation through reflationary policies aimed at boosting economic growth and, as a result, increasing tax revenue. While government expenditures for FY 15 are the largest in history, tax revenue is expected to be its highest since the era of the bubble economy. As a result, the fiscal balance is expected to improve.” The broad categories of reform include a huge range and diversity of initiatives including: 

1) overcoming population decline and revitalising the local economy;

2) revitalising private investment;

3) enhancing corporate governance;

4) labour market reform;

5) promoting women’s participation in the workforce,

6) technology and innovation,

7) agricultural reform,

8) healthcare reform,

9) financial reform for households and businesses;

10) energy sector reform

Crucially this push for economic and political reform is being accompanied by a huge quantitative easing programme on an unprecedented scale – with potential for even more expansion in October 2015. 

 

 The chart above from Simon Ward, Chief Economist at Henderson’s Global Investor outlines the sheer scale of this quantitative easing programme, breaking down the various components of local broad money supply. Notice the massive increase in Bank of Japan lending to the government (source - http://moneymovesmarkets.com/journal/2014/8/19/japanese-qe-still-isnt-working.html).

 Yet this huge programme of legislative and policy reform might well face significant headwinds over the next few years – so far there’s little evidence that inflation is actually taking hold in Japan despite all this QE pump priming.

 In the absence of rising prices and rebounding consumer demand Abe needs to move fast – he’s strongly committed to ensuring that the consumption tax hike now scheduled for April 2017 will not be delayed again and will be implemented irrespective of the economic situation. In other words, he is committed to reflating the economy ahead of April 2017. Therefore, reflationary pressure needs to start feeding through in 2015.

 But investors also need to pay attention to a profound change in Japanese corporate culture. Japan’s first corporate governance code came into effect on 1st June with the intention of improving transparency and accountability to shareholders, such as the appointment of independent outside directors. According to Michael Stanes at Heartwood Investment Management this governance reform potentially “represents a watershed moment because although the code is voluntary, companies are expected to be ‘shamed’ into following best practice through the tool of moral suasion“. 

 One crucial form of moral persuasion consists of the recently launched JPX-Nikkei 400, dubbed ‘the shareholder friendly index’. This government inspired index focuses on Japanese businesses with a  strong focus on return on capital, and is already encouraging Japanese corporates to strive towards being part of the ‘good company club’. According to Heartwood’s Stanes “there have also been more examples of shareholder activism to improve shareholder returns. Japan’s largest institutional investor Nippon Life has stated that it would consider exercising voting rights for companies that fall short of expected standards, including delivering an average of 5% return on equity over five successive years".

 This strong push for both macroeconomic and corporate reform is already having an impact on Japanese corporate profits and balance sheets – the falling value of the yen is helping exporters and even domestic companies are rebuilding balance sheets and boosting dividends. In sum, Corporate Japan is in relatively rude health, especially if FY 2014 numbers are anything to go by.

 According to Genzo Kimura, economist at SuMi TRUST, the largest asset manager in Japan (US $453 billion AUM) “Corporate earnings for Japanese companies whose accounting period ended in March 2015 may not have achieved the double digit growth of 2013, but this is now the third consecutive year of operating profit increases. The tailwind of the weakening yen has given rise to strong performances from export related industries, including electronic parts and automobile manufacturers, which have driven corporate earnings growth. Based on the independent research from our analysts, we forecast an increase in operating profits of 17% and over for the 2015 fiscal year to March 2016….March 2015-2016 fiscal year the operating income of listed companies, excluding finance, are predicted to increase by nine per cent year-on-year. Furthermore, in this first quarter more companies are likely to announce measures for shareholder returns, including dividend increases and share buybacks, in preparation of the formal introduction of the corporate governance code this month".

 On a sector by sector basis most analysts now expect double digit growth in both, manufacturing and non-manufacturing (11%) sectors. This surge in profits will help rebuild Japanese corporate balance sheets. The debt to equity ratio of non-financial Japanese corporates for instance stands at a 20-year low and that downward trend has continued over the past year, in contrast with the US. Cash balances have increased significantly where the average Japanese company sits on 20% of its market value, largely due to capital expenditure restraint and improving profitability -Japanese companies are at their most profitable in 30 years. In fact Dividend pay-outs and share buyback activity exceeded expectations in May with share buybacks reaching nearly ¥1 trillion, a record for a single month. 

 My own sense is that we are potentially only early to mid-way through a bull cycle for Japanese equities. PM Abe has to show results in 2015 and my perception is that he’ll do almost everything to boost momentum domestically. That means more QE, an even weaker Japanese yen (the real effective exchange rate is already at its lowest since the early 1980s), corporate tax cuts and extensive reform – they’re all designed to reflate the Japanese economy and he needs to show evidence of success almost immediately. I’d be astonished if this massive barrage of activity doesn’t have some impact, and the improving state of corporate balance sheets and P&L statements will (hopefully) eventually feed through into stronger consumer demand and wage increases. Given this backdrop I’d be tempted to go with the flow and be overweight Japanese equities with the proviso that investors should almost certainly consider some form of hedged equity exposure.

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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