Tuesday, February 17th, 2015

Gogi Ichiba

For the last two months Japan has been our preferred region for any investor running a fully-hedged equity portfolio. The hedge is not necessary to protect them from currency losses; it is just there to stop the strength of the dollar getting in the way of like-for-like comparisons. We still find that this call is greeted with a mixture of scepticism and indifference. So, on the day when Topix has closed at a new eight-year high, here is a list of reasons why we think that the bull market in Japan is still only in its infancy.

Currency depreciation: Competitive devaluations are demonised for causing the 1930’s depression, but the dirty secret is that they work so long as everybody else plays by the rules. It worked for the US and the UK in 2009 and 2010. It is working for the Eurozone now and it started working for Japan in 2013.

Monetary policy: The principle impact has been on the yen, but domestic bank lending is an equally important part of the story. In Q4 2014, this rose at its fastest pace since 2008 and the stock of loans to the private sector is now higher than any time since 2002.

Oil prices: Japan is energy poor and therefore one of the biggest beneficiaries of falling energy prices. This huge variable is completely outside the scope of Abenomics, but it suggests that Mr Abe is a lucky politician as well as a good one.

Political stability: Whatever the reason for last November’s snap election, the result is clear – a fully-empowered government with a mandate for reform and a full term ahead of it. Every other major economy will have elections before their next scheduled elections.

The reform programme is still an ideal rather than a reality, but lower headline corporate taxes, the postponement of the next round of the sales tax and the relaxation of limits on equity ownership for public-sector pension funds are all market-friendly initiatives.

Economic recovery: Japan’s recent performance has been patchy and the flash estimates for Q4 GDP are below estimates. But recent real-time data is consistent with acceleration back toward 3% annualised growth, on a par with the US and the UK.

Valuation: We don’t normally talk about this, but other people think it’s important. A prospective PER of 14x is much cheaper than 17x for the US. Return on capital of is 8% vs 14% for the US, which suggests that there is scope for efficiency improvement as well as economic growth.

Chart: If the index can hold above the high it has just broken through, the next resistance level is 14% higher, so there is plenty of upside from a technical perspective and nothing to indicate that it is overbought in the short-term.

Geography: Japan is a long way from Greece and the Ukraine. If either of those two crises go critical, Japan may even benefit from safe-haven flows.

Risks: The biggest risk is a major Chinese devaluation, but we think the authorities there remain wedded to the gospel of gradualism. In a perverse way this would also be an acknowledgement by China that there was renewed dynamism in its oldest competitor.

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