Japan ’s reflation policy remains on track

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Mikio Kumada, global strategist at LGT Capital Partners argues that recent Nikkei 225 gains make it harder to keep ignoring Japan and should thus add to the market’s upward momentum over time.

Japanese equities have been outperforming since late 2012, even though much of the punditry on the country’s effort to shake off deflation remains rather lukewarm, while a weak yen has offered another convenient excuse to shun the market. Still, just last week, the Nikkei 255 hit a 15-year high even in US dollar terms. Such gains make it harder to keep ignoring Japan, attract further investor attention, and should thus add to the market’s upward momentum over time.

At face value, Japan’s economy continues to disappoint. Last November, official quarterly gross domestic product data showed an unexpected fall back into recession in the third quarter of 2014, forcing Prime Minister Shinzo Abe to call a snap election. Just yesterday, fourth quarter GDP, which had already disappointed expectations, was revised down further. The government’s economic policies, known as Abenomics, seem to be stalling.
The truth, of course, is more nuanced, if not contradictory, as the market itself suggests. For example, even when viewed in USD terms, Japanese stocks have actually outperformed all other major developed markets since that presumably horrible Q3 GDP report was published on 17 November (Nikkei 225: 5.8%, EuroStoxx: 0.9%, Hang Seng: 0.3%, S&P 500: 0.1%, FTSE 100 0.5%, SMI: – 2.2%). But the long-term USD-based view is even more interesting.

Are markets too optimistic about Japan?
Last week, the Nikkei rallied to the highest level since October 2000. In doing so it broke through a technical downtrend that has been in place since 1994 and thus overcame its second, and last, long-term barrier (see PDF, page 3). The market is clearly signaling Japan will be able to break free from its deflationary stagnation – and we believe this view is not misplaced. If anything, optimism about Japan still appears to be relatively controlled in the larger frame of things.

Firstly, Japan still has a huge catch-up potential compared to other markets, as stock prices have remained relatively depressed for 15 years, while Japanese corporate profit continued to grow in line with global developments. Specifically, earnings per share for the MSCI Japan are now 3.3 times higher than in 1995, compared with a 3.1-fold gain for the rest of the world. However, the MSCI Japan still trades only 30% higher than in 1995, while the global index is up 240%, or 3.4 times. This valuation gap can ultimately be explained by one word only: deflation. Consequently, if deflationary expectations can be permanently cast out, Japan should be able to close that gap, as Japanese companies are not less profitable than companies elsewhere.

Secondly, the very GDP reports that seem to disappoint many analysts actually confirm that Abenomics is working quite well so far. In this context, we should distinguish between the nominal and the inflation-adjusted, i.e. real, data. While most media and analyst reports typically focus on the real numbers, the nominal statistics are far more significant in Japan’s case at this stage (the real data will become important at a later stage, once stable inflation has returned into the system). At any rate, the nominal numbers show that nearly all previously stagnant or declining GDP components have returned to growth following the launch of Abenomics. At the same time, GDP segments that had been less affected by Japan’s deflation, such as exports and imports, have accelerated their growth rate over the past two years (see PDF, page 2).

New USD-based highs attract international attention
Finally, as Japan’s indices continue to perform well and hit new highs even in USD terms, global investor attention will only continue to increase – undermining the frequently used excuse against investing in Japan (i.e. the weak yen). In other words – as reflation works its way through Japan’s economic system, time is on the side of those who are long Japanese equities.

Deflation has devalued Japan’s corporate earnings performance
If we compare Japan with the rest of the world (MSCI All-Country World excluding Japan) in terms of the level of stock prices and corporate earnings, in USD. The global index shows that over the past 20 years, prices have broadly moved in line with corporate earnings, although there were periods of stronger deviation in between. Japan represents the major exception, as stock prices there have been moving sideways to slightly lower over the past two decades, even though earnings have been largely growing in line with the global trend. In other words, persistent deflation had imposed a very big discount on Japanese equities. As inflation returns into Japan, this discount should continue to decrease going forward.

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