Takeo Aso and Nicholas Davidson
Current bearishness on the yen is reigniting investors’ interest in Japanese equities. In our view, yen weakness is likely to continue and may help boost the Japanese equity market, with undervalued companies poised to benefit most.
The prospect of victory for the opposition Liberal Democratic Party in next week’s elections has raised expectations of a potentially radical shift in Japanese monetary policy. If a concrete inflation target is set or the central bank decides to purchase foreign bonds, the yen’s decline is likely to continue. Traders today are already betting more heavily against the yen than any other developed currency.
Could bearishness on the currency signal an opportunity in Japanese equities?
In recent years, a falling yen has often accompanied a rally in Japanese stocks. Overseas investors, who have become increasingly important in driving Japanese equity prices, tend to see a falling yen as good for the country’s exporters and therefore for the Japanese market as a whole. In our view, this relationship is overstated, since large Japanese manufacturers such as Honda and Toyota have shifted a lot of production to their overseas markets. Still, these types of financial market dynamics are often self-reinforcing; a weak yen may well continue to be associated with gains for the Nikkei.
From a fundamental point of view, prospects for the yen do look poor. The recent move into deficit of the Japanese balance of trade reinforces the yen’s position as a likely main funding source for carry trades into currencies that still offer positive interest rates. Even if expectations of a major monetary policy shift are overdone, as we suspect, further falls in the yen look likely.
Any tailwinds from currency moves will bolster an attractive valuation case for Japan today. After many years of trading at a premium to the rest of the world based on price to trailing earnings, Japanese equities today trade pretty much in line with global stocks. Investors are not pricing in improved forward earnings prospects for Japanese corporations, as they continue to recover from the devastating impact of the 2011 earthquake and subsequent floods in Thailand.
Over the last 40 years, value metrics like price to book, price to sales and price to cash earnings have been the best predictors of future stock returns in Japan (Display). Perhaps surprisingly, companies scoring best on profitability metrics like return on equity (ROE) and return on assets (ROA) have on average underperformed. In the first nine months of 2012, however, value factors worked very poorly in Japan, while returns of the most profitable companies were much better than the market.
This atypical pattern now looks to be reversing. As investors worry less about the euro falling apart, and spend more time looking at company fundamentals, they seem again prepared to buy unloved, deeply discounted companies. As a result, in Japan as elsewhere, value stocks have started to outperform in recent weeks. While the elections will be over in a few days, the time to vote for Japanese stocks may be just beginning.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Takeo Aso is Director of Research—International Value Equities and Nicholas Davidson is Senior Portfolio Manager at AllianceBernstein.