The Japanese economy has been hit by weak exports
In the third quarter, compared to the previous one, the Japanese economy contracted by 0,9%. The main cause can be traced back to a sharp decline in exports, private consumption and corporate investment. The drop in consumption was more or less expected, given the end of the incentives on ecological cars, so the real negative surprise is the data on exports. The situation here is mostly due to the dispute with China and the strength of the yen. Given the persistence of tensions with China and the decline in results on many macro data, we expect a contracting economy also for this quarter, the second in a row.
A more expansive fiscal and monetary policy would be desirable
We expect the Japanese economy to regain momentum in 2013, especially now that the likelihood of more policy intervention has increased. Elections are scheduled for December 16 and polls suggest that the opposition LPD party is in a good position for a victory. The leader of this party, Shinzo Abe, has identified the country's major problems with persistent deflation and the strength of the yen. We strongly agree with this position. To combat these problems, Abe argues for the need to increase the fiscal budget for 2013 to include a public works plan with annual disbursements of around 1-2% of GDP. Abe also proposes cutting corporate taxes and making the planned increase in consumption taxes (from 5% to 8% in April 2014) conditional on the end of deflation. And finally, there is a request to the Bank of Japan to introduce decisive accommodative monetary policy measures to counter deflation. The central bank should therefore raise the inflation target to 2-3%, compared to the current 1%. In Abe's program, we also read of greater coordination between the Government and the Bank of Japan, a euphemism for less independence. And looking specifically at Japan, in our opinion that wouldn't be such a bad thing.
The market reaction was positive
The Japanese market has reacted very well to these statements. Indeed, the proposed measures are positive for both the economy and the stock exchange. History shows a strong correlation between a weak dollar (and therefore a strong yen) and the underperformance of the Japanese stock market relative to the market as a whole. This trend can be explained by the high export sensitivity of listed Japanese companies. A weaker yen would give an immediate boost to exporters' profits. It is therefore not surprising that immediately after the announcement of the elections, the greatest increases were in financials, consumer discretionary (auto) and materials. The more domestic sectors, consumer staples, telecommunications and healthcare, underperformed.
A catalyst for performance
If the Bank of Japan introduces unlimited quantitative easing, as the US and Europe have already done, we may perhaps have the catalyst to finally unlock the value in the Japanese equity market. Japan is an underappreciated market, it is undervalued and largely ignored by global investors, with the lowest net exposure in a decade. At the same time, however, some flows towards the Tokyo Stock Exchange are being recorded.
The recent easing of monetary policy
Naturally, facts count and Japanese politicians have often disappointed expectations. In any case, firm monetary policy accommodation would be good news for markets. Recently the Bank of Japan announced a rather unusual measure, quantitative easing for the second month in a row, expanding the purchase program from 80 to 91 trillion yen. Even if for the moment the most decisive element for Japan is what will happen overseas, the Central Bank, albeit cautiously, has shown that it is moving decisively to counter deflation. However, there is not only positive news. In fact, Abe seems to want to adopt a very resolute position regarding the territorial dispute with Beijing regarding the Senkaku Islands and this could have repercussions on trade between the two countries. At the moment, our position on Japanese equities is neutral, but we believe Abe's comments could introduce a positive element of novelty, obviously if he is elected. Foreign investors should consider a depreciation of the yen by implementing a currency hedge.
The ratings are extremely low
One last thing to note is the extremely attractive valuations of Japanese equities. Approximately 70% of the 1.600 Topix-listed companies currently trade below their book value, and hundreds of companies with very low default risk trade at a multiple of less than 0,5x. In a market whose recovery has stagnated significantly, earnings (P/E ratio) have also followed the same trend. Over the past ten years, the market's P/E has dropped from 20 to 12, while the price-to-book ratio has dropped from 1,2 to 0,9.
