Asia insights

Warming up to Japanese equities

The surprise resignation of Prime Minister Yoshihide Suga has invigorated a sluggish Japanese equity market on hopes for more economic stimulus and a fresh face leading the country in its post-Covid restart after a general election in comings months. We upgraded Japanese equities from underweight to neutral in our midyear outlook two months ago. What next? Our stance remains that there are some clear positives – including earnings momentum, globally attractive valuations and the potential for an upswing caused by removal of Covid-19 activity restrictions – even with the uncertainties. These include the virus, semiconductor shortages, the political backdrop, and broader issues in the Asia-Pacific region – China’s slowdown – which directly impact the Japan equity market.

Japan’s vaccination rate is improving fast – see our Covid tracker. Japan has set a target that 60% of the population will be fully vaccinated by the end of September, which seems doable to us. This situation of virus vs. vaccine is dynamic and evolving in real time. We believe that the ramp-up in vaccination will set the scene for an activity restart in coming months. The market is already starting to look beyond the state of emergency, especially as new cases peak in the Tokyo area.

The rising Covid case count in Japan has had knock-effects in the political sphere. Prime Minister Suga, suffering low ratings in the polls, decided not to run for the Liberal Democratic Party (LDP) leadership, setting the stage for a leadership race and new prime minister after a national general election due by November. Vaccine minister Taro Kono is the favorite in the polls over Fumio Kishida, both former foreign ministers [source].  Both are pledging a continuation of the Abenomics – the loose fiscal and monetary policy launched under former Prime Minister Shinzo Abe. With Kono advocating a reform of social security and welfare, the unachieved third arrow of Abenomics: structural reforms. In late September, the ruling LDP party will conduct an internal party vote to decide on its leader. Polls suggest the ruling Liberal Democratic Party and its coalition partner Komeito is overwhelmingly likely to remain in control at the national level, meaning the new LDP leader is likely to be the next prime minister. We see the LDP leadership contest as likely spurring a generous economic package by whoever comes out on top – the Topix index is up 5% already this month, as of Sept 21, according to Refinitiv data.

Yes, the change takes time. But we believe we are seeing a gradual move toward a somewhat more shareholder-friendly environment. Perhaps the clearest example of this is the ongoing increase in the combined cash returns to shareholders via buybacks and dividends, according to Bloomberg data as of the end of August.

For these positives, investors are certainly not being asked to pay up. Japan’s equity risk premium is still above its long-term median in contrast to the U.S. and Europe: see BII and RQA’s Market Risk Monitor. And the relative valuation appeal of Japan is even stronger than usual: Japan’s price-to-earnings discount vs. the U.S. equity market is the largest in a decade, according to Refinitiv data as of 18 September, 2021. We think that if Japan were to start to outperform, there could be the risk of a squeeze higher as investors hurry to close their underweight positions. Last week saw foreign inflows perking up for the first time in five months.

But what would be the catalyst for this? Certainly, the removal of some of the current uncertainty. We have some rather straightforward signposts that can help give us some confidence that this uncertainty should start to reduce. First, more confidence in the global restart. That would likely be reflected in higher U.S. Treasury yields, a renewed steepening of the U.S. yield curve and greater confidence in the cyclical trade that has been closely linked to swings in U.S. long-term yields. Second, vaccination rates. The UK, the U.S. and some other countries have shown it is possible to open the economy while mitigating the worst of the negative consequences of the virus. As Japan quite quickly takes its vaccination rates from 40% to 60% in the coming weeks, the reopening will become clearer. Third, we should see the reduction of political uncertainty on a similar timeframe. By the end of September, we will know who will lead the LDP into the coming general election – and have a higher degree of confidence on policy direction.