Japanese Equities – Don’t Miss The Train…

This magazine has been a big bull of Japanese equities since the beginning of the year and we took the opportunity to re-iterate our Bullish stance in the 3rd quarter of this year with the Nikkei trading at the time around the 8700 level. On the 5th of October we posted the following blog – http://www.spreadbetmagazine.com/blog/2012/10/5/a-pairs-trade-idea-in-the-nikkei-225.html, we referred to the material underperformance of the Nikkei 225 when compared with the other main indices this year and re-iterated the extreme undervaluation of the Japanese market when looking at fundamentals.

Since that point, as we can see below, the Nikkei 225 has outperformed the S&P500 – the global benchmark by almost 10%. From outperforming materially in the early part of the year and then giving it all back during the summer, the Nikkei is currently level pegging with the S&P 500 on a YTD basis (in local currency terms).

Nikkei 225 V S&P 500 since 5 Oct 2012

Forthcoming Elections

For several years now, investors have been pulling money out of the Japanese equity market, seemingly oblivious to cheap valuations and in reality chasing performance elsewhere around the globe. The imminent election in Japan which is likely to result in the replacement of the current Japanese Prime Minister Yoshihiko Noda with LDP candidate Shinso Abe promises to be a watershed moment for the Japanese economy. Abe is a big advocate of targeting inflation at 2% and ridding Japan once and for all of the deflation that has plagued the country for nearly 15 years now.

Should Abe prove victorious in the election then it is likely that the momentum behind the current Yen slide will pick up. This is the smoke signal for the equity market to begin to motor into 2013 in our opinion as the Japanese economy is heavily export dependent. In fact, every 1 yen move in the yen:dollar pair has an outsized effect on the Japanese economy, particularly around the current levels of 82/3 – which is breakeven for many exporters. Should the yen pop out towards 90, we can expect to see the Nikkei vault back over the key 10000 level.

Despite efforts by the current Government and the Central Bank to stimulate the economy in recent years, the Japanese equity market has been moribund for several years. Debt has risen to more than 200% of GDP, interest rates have come down to near zero, the BOJ has attempted, in vein this far in the last 2 years, to sell the Yen and contain its strength. Throughout this period the equity market has largely gyrated between 8000 and 10000 and only the Fukushima nuclear disaster and the Tsunami caused a brief break out of this range. Meanwhile its neighbour and rival China has been experiencing more than two decades of enviable growth all the while Japan has been struggling just to simply stand still.

We can see from the chart below what while the U.S. stock market has recovered extensively since the financial crisis hit the world in 2008, Japan has lagged materially.

Generational Buying opportunity

The Nikkei 225 bottomed on March 10, 2009 at 7,055 and is now up almost 30% but that is nothing when compared with the 93% growth that the S&P 500 has been experienced. Even though growth in U.S. has been higher over the last few years, the equity market in Japan is now at a 40 year valuation. The price to book ratio is less than one in Japan while it is above two in the U.S. Japan’s price/earnings ratio is also just a bit above 15, a level not seen in decades. Finally, the dividend yield is very high in real terms for a country that has no inflation. In short, we believe that the equity market is poised at a once in a generation buying opportunity.

A Weaker Yen To Come

It looks increasingly likely that the exceptional strength seen in the Yen over the last 5 years has come to end. Already, after just a 3% move in the last 2 weeks as we approach the election, numerous currency “anal”ysts are saying the weakness has moved too far too soon. What are they smoking? If Abe gets his way then 79 – 82 yen will be put a blip on the chart. We think that an aggressive monetary easing program with a targted inflation measure of 2% will drive the Yen north of 90 through 2013. Fighting the Yen for the last 5 years has been a losing game and this type of entrenched psychology is hard to shift – when the turn comes, so many people who have been burnt cannot believe that a real move is afoot. It is of course human nature to disbelieve after so many false dawns – akin to the “cry wolf” story.

The BOJ has not been able to put a floor under the USD/JPY in a credible way despite attempts in recent years. In large part this is through having to fight against the will of “Helicopter” Ben Bernanke who has been hell bent on debasing the U.S. currency through all the quantitative easing programs he has been unfolding since 2008. The market is however smelling the end of QE in the US. And if the BoJ embarks on a renewed program, just as the Fed is ending theirs, we think this is the sort of seismic shift that the FX market has been waiting for to aggressively push the Yen lower. We believe the BoJ should take a leaf out of the Swiss National Bank’s book last year and stand behind a targeted level of say 90 Yen:dollar. 

The pair bottomed at an all time low of 75.54 on October 31, 2011 and has been rising steadily since. It currently trades at 82, or just over 8% higher.

A Boost to Equities

Over the last 5 sessions the Nikkei has risen 5.5% while the S&P is up just 0.5%. During the next few sessions volatility is likely to rise ahead of the parliamentary election day in Japan. We expect to see overseas fund managers picking up Nikkei companies again once this is out of the way as they are largely underweight.

The opportunity we believe is presented today is not a short term one but rather something to consider for a 3-4 years investment. The best way would be to invest through an ETF that hedges for currency risk as of course any yen weakness will mute returns in sterling or dollars. Of course, a big bonus with a spreadbet on the Nikkei is that the currency risk is hedged for you as you will be betting in sterling. You will have to take account of rollover costs however and which can be substantial in a 3 to 4 year period. The use of the farthest maturities instead of daily rollovers will help flatten those costs and are definitely recommended.