Quarterly Outlook
Equity outlook: The high cost of global fragmentation for US portfolios
Charu Chanana
Chief Investment Strategist
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Out of Hibernation: A primer on the Japanese equity market
Peter Garnry
Chief Investment Strategist
Summary: Key points in this equity note:
- Japanese equities have outperformed the global equity market in 2023 attracting a lot of attention from investors including renowned investor Warren Buffett.
- For foreign investors it is important to consider the JPY currency exposure given the large interest rate differential and potential monetary policy change from the Bank of Japan.
- The Japanese equity market provides the investor an overweight to industries such as industrial machines, commodity trading and distribution, and car manufacturing.
- The AI hype in 2023 has also spread to the Japanese equity market with the semiconductor testing equipment manufacturer Advantest rallying 131%.
- Key risks for Japanese equities are related to a slowdown in the global economy and in particularly a pivot in monetary policy by the Bank of Japan which could led to an appreciating JPY eroding competitiveness for its export industries.
Japanese equities have come out of hibernation
The Japanese equity market, as represented by the Topix 500 Index, is up 18.2% in local currency terms this year (through 11 July 2023), posting a better performance than most equity markets. Back in April and May we wrote two equity notes on the Japanese equity market: Will the sun rise over Japanese equities? and Japan and Greece: the two comeback countries. They highlighted the strong performance of Japanese equities and some of the potential drivers behind this. Some of the interest in Japanese equities due to legendary investor Warren Buffett's “marketing” of them, as he bought 5 Japanese trading companies in the early days of the pandemic. But there are more important and durable drivers as well, such as the Bank of Japan monetary policy and the weak Japanese yen.
For domestic Japanese investors, inflation, combined with a stubborn monetary policy will mean that real wealth is being eroded for holders of Japanese bonds. After decades of actual deflation or very low inflation where Japanese investors’ portfolios have been filled with bond, Japanese equities have suddenly become important to offset the risk of negative real returns. Another boon for Japanese equities has been the Fed’s inflation-fighting policy pivot back in late 2021, which led to significant increases in policy rates in 2022. The aggressive Fed hiking has widened the interest rate differential between the US and Japan, sending the USDJPY exchange rate 23% higher since December 2021. As Japan’s economy and equity market are driven by exports, the falling JPY causes revenue and export growth to accelerate for Japanese companies, which has a positive effect on the Japanese equity market in local currency. While Japanese companies have become more capital efficient, they are still sitting on vast cash balances with the net debt (interest bearing debt minus cash and cash equivalents) at negative JPY 357 per share in the MSCI Japan Index. This means that the Enterprise Value to EBITDA ratio (EV/EBITDA, a useful valuation metric that is also generally the value taken into consideration for takeover targets) for Japanese equities is 61% lower than for US equities. The lower EV/EBITDA means that Japanese equities are less sensitive to higher interest rates and that there’s a considerable upside potential from valuation expansion (that Japanese equities get valued at higher valuation multiples like global equities), should the positive narrative about Japanese equities continue.
Japanese equities: Industrial machines, commodity trading, and cars
The Japanese equity market has a combined market value of USD 3.5T, which is less than 10+% of the US equity market valued at around USD 39T. Despite being dwarfed by the US equity market, the Japanese equity market is 6% of the MSCI World Index , making it the second largest single country equity market in the world. Investors exposed to the Japanese equity market get an overweight to industrials and consumer discretionary sectors and a significant underweight in the information technology sector. This explains some of the relative performance in 2022 between US and Japanese equities in local currency terms. US equities were hit hard by rising US interest rates, which resat equity valuations, while the weaker JPY helped boost exports in the industrials and consumer discretionary sectors.
If we take a step further down the classification hierarchy, it is evident that the two largest industry groups are capital goods and automobiles & components. These are driven by three main industries: automobiles (carmakers such as Toyota, Honda, and Suzuki), trading companies & distributors (the five trading companies Berkshire Hathaway bought stakes in), and machinery (which are companies such as SMC, Fanuc, Komatsu, and Mitsubishi Heavy Industries). In other words, buying Japanese equities offers exposure to the global economy through industrial machines, trading in physical commodities, and cars. These industries are so unlike the red-hot AI related companies in the US, but nevertheless important companies for the global economy.
Japan’s largest companies and the hope of AI
The four largest companies in the Japanese equity market are Toyota, Sony, Keyence, and Mitsubishi UFJ Financial. Toyota remains the largest carmaker in the world with an annual revenue of USD 275bn, but its outlook has deteriorated with the widespread adoption of battery electric vehicles (BEVs). Toyota has so far been betting on hybrids and fuel cells, but the new CEO has recently admitted that Toyota has been too slow to buy into BEV technology and the company is now committed to catching up with the industry and in particular Tesla and Chinese EV makers.
Sony is a technology conglomerate spanning many different businesses such as gaming, music, imaging solutions, pictures (movie production), and electronic products such as TVs. While Sony is not growing at the same rate as US technology companies it is still one of the crown jewels of Japan with an annual revenue of USD 85bn and an operating income of USD 16.3bn.
Keyence is a lesser known, but innovative, company specialising in developing and manufacturing industrial automation and inspection equipment, such as machine vision systems for factory production and barcode readers. It generates around USD 7bn in annual revenue. This stock is one of the top stocks held by many of the ETFs tracking robotics and automation.
The AI hype has not escaped the Japanese equity market and scanning this year’s best performing stocks, we find a Japanese semiconductor equipment company called Advantest, which is Japan’s leading manufacturer of automatic test equipment for the semiconductor industry. The stock is up 131% this year as of 11 July 2023 as investors are betting that the boom in semiconductors related to AI will also lift Advantest’s growth outlook. Since the Great Financial Crisis lows in February 2009 the total return in Advantest has been 23.1% annualised (including reinvestment of dividends), underscoring both the high growth and equity valuation expansion in semiconductors stocks, but also the success among Japanese technology companies operating in niche industries. Key risks to Japanese equities
The points made in the beginning about the importance of the JPY for the returns in Japanese equities for a foreign investor are key to understanding the underlying risk. The Bank of Japan has been the odd one out in maintaining its policy rate at -0.1% compared to US and European policy rates of 5-5.25% and 3.5% as of 12 July 2023, respectively. If the BoJ reverses its monetary policy and goes down the path of policy rate convergence with the rest of the world, the JPY might increase sharply and trigger a slide in Japanese equities, not to mention slowly eroding the carry returns for foreign investors.
Another obvious risk to Japanese equities is a general slowdown in the global economy as the Japanese economy is leveraged to export demand and would likely be hard hit in such a scenario, especially given the types of industries featured in Japan’s equity market. Competition from Chinese and South Korean companies across industrial machines and car manufacturing is also a threat to the Japanese equity market over time.
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