Japanese Marmite

Kerry Craig

Since the start of Abenomics, Japan has been a bit like Marmite for investors. But a belief in the success – or otherwise – of prime minister Shinzo Abe’s plan to reignite the economy may not be the right investment thesis for Japan.

There are other reasons why equity markets may continue to move higher. The country’s deep-seated economic challenges should make any long-term investor stop and think, but a few things are starting to swing in Japan’s favour, and the market may well be worth another look.

The most obvious attraction of the Japanese market is the price. Compared with many other developed markets – and its own history – it looks cheap. Even though the Nikkei 225 is up 13 per cent so far this year, and 180 per cent since its low in March 2009, the current forward price/earnings ratio of 18.9x is below the last 15 years’ average of 21x.

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Marmite haters will say that it is just the weaker currency and not a genuine improvement. However, unlike 2013, when market gains were accompanied by a significant depreciation in the yen, this year’s gains show no more than enthusiasm based on central bank balance sheet expansion. In fact, there could be a combination of factors at play, as follows.

Earnings momentum: Japan had the strongest earnings momentum of all three major developed regions in the last quarter of 2014. What is more, some 67 per cent of Topix companies beat earnings expectations – the highest level in five years – and if we exclude energy companies, earnings a share grew at 8 per cent year-on-year. This week’s chart shows that more companies are seeing their earnings outlook for the coming year revised up than down.

Flows: Japanese equities should benefit from continued support from official institutions as the Government Pension Investment Fund needs to invest US$59bn in Japanese equities to achieve its target of a 25 per cent equity weighting. The Bank of Japan (BoJ) is also looking beyond bond purchases and is expected to invest US$25bn in the domestic equity market as part of its programme of qualitative and quantitative easing. But the secondary impact is just as important. Even if a small portion of the US$4.8 trillion invested in the domestic pension fund and insurance industry follows the money from the GPIF, the effect could be quite significant.

Corporate governance: Both the BoJ and GPIF are investing through a newly created index, the JPX Nikkei 400 Index, which comprises companies meeting certain investment standards such as return on equity and corporate governance. The investments will be published, and should encourage companies that are not part of the JPX Nikkei 400 Index to improve their corporate governance and put greater emphasis on shareholder returns.

Cheap oil: Japan imports more energy than most developed economies, at 3.6 per cent of its GDP, but this means that it has the most to gain from the fall in the oil price – even when considering that cheap oil leads to disinflation, which is what Abe is trying to prevent.