While Japanese stocks are down a bit from then, the Japanese market, as measured by the MSCI Japan index, is still up roughly 15 percent this year, outperforming the broader MSCI ACWI index global market, according to mid-July Bloomberg data.*
Japanese stocks’ strong performance has prompted some market watchers to question whether there’s still a case for adding exposure to the Land of the Rising Sun.
They’re worried that the market will soon lose steam, as one of the major recent buyers of Japanese stocks-the Government Pension Investment Fund (GPIF)—is set to hit its target equity allocation as soon as this month.
I still see opportunity in the Japanese market for the following key reasons.
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While Japanese valuations have increased over the past year, they remain more attractive than those in the rest of the developed world and the broader market, on both a price-to-earnings (P/E) and price-to-book (P/B) basis, according to 7/12/15 Bloomberg data. In fact, in mid-July, according to Bloomberg data, the P/B for Japan was still half that of the U.S. It’s also worth noting that Japanese stocks remain inexpensive even after outpacing their major developed market counterparts year-to-date due to strong earnings momentum, according to Bloomberg data.
Strong earnings momentum
As my colleagues and I write in Investment Directions, Japan’s economy, while certainly not a locomotive, has managed to pull out of a shallow and brief recession, and it’s beginning to show signs of benefiting from a weaker yen. This is helping Japanese companies continue to improve their profitability. Last year’s conservative estimates and corporate governance reform are also helping to improve the earnings picture.
Improving return on equity (ROE)
Japanese corporations are putting more emphasis on shareholder value and are increasingly returning cash to shareholders in the form of dividends and share repurchases. As of July 12, ROE in Japan was up 30 percent from 2012, according to Bloomberg data. Looking forward, as Japanese companies can potentially continue to improve their profitability, ROE may increase further this year and next.
A market-friendly central bank
While the Federal Reserve (Fed) will likely begin raising rates later this year, the Bank of Japan (BOJ) remains in easing mode and is planning to continue to expand its balance sheet, providing a potential tailwind to the country’s stocks.
Increased equity buying by institutions
The Japanese market has benefited from the GPIF and other institutional buyers increasing their investments in Japanese equities. While the GPIF rebalance is almost complete—the fund will likely reach its target allocation of 25 percent this month-other pension funds could also increase their equity exposure, given that the GPIF rotation contributed to record returns for the fund. In addition to pension funds, Japan Post—Japan’s largest bank, insurance company and employer—may also shift some of its assets to stocks from bonds.
Underpinning the above case for Japan is the country’s changing macroeconomic picture under the reform policies of Prime Minister Abe, known as Abenomics. Now into in its third full year, Abenomics consists of a three-pronged (or three-“arrowed”) approach: aggressive monetary policy to end deflation, expansionary fiscal policy to give a boost to the economy and finally, a pro-growth strategy to enhance conditions for longer-term growth and improve corporate competitiveness. Examples of this third arrow include the GPIF’s bigger allocation to equities and reforms to encourage shareholder-friendly corporate activity.
So, while Japanese equities have done well lately, it’s important to remember that their performance has been driven by the results of Abenomics, namely quality earnings growth and shareholder-friendly policies, rather than just multiple expansion.
The Japanese market does face potential headwinds, including high public debt and an aging and shrinking population. In addition, there are a number of scenarios that could derail the rally in Japan, such as a significant global slowdown and inflation stemming from a declining yen. But these scenarios seem unlikely today. Given all this, Japan may remain a stock market worth considering.
Exchange traded funds (ETFs) such as the iShares MSCI Japan ETF ( NYSEARCA:EWJ) or the iShares Currency Hedged MSCI Japan ETF (NYSEARCA:HEWJ) can provide access to the Japan market.
Heidi Richardson is a Global Investment Strategist at BlackRock. She is also Head of Investment Strategy for U.S. iShares.