FOCUS NOTE JAPANESE EQUITIES AN UNEVEN PICTURE SUMMARY

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1 SUMMARY BANK OF JAPAN, THE CORNERSTONE OF ABENOMICS From mid-december 2012, when Shinzo Abe came to power, to end-june 2018, the increased by 12% in local currency on an annualised total return basis, a significant achievement that owes much to Abenomics. At the same time, the Bank of Japan (BoJ) has had a direct impact on equities through its commitment to buy 6 trillion yen of equity ETFs annually. Jacques Henry, Senior Cross-Asset Strategist, Pictet Wealth Management SHAREHOLDER RETURNS HAVE IMPROVED Not only corporate governance has improved in Japan but also shareholder returns. Currently at 2%, the average dividend yield has been on a par with the US for two years and buy-backs turned positive in ROE and operational margin have improved steadily as well but further progress is needed to bridge the gap with the US and Europe. Half of Japanese companies are net cash, but unevenly across sectors and across company size. CORRELATION BETWEEN YEN AND THE WILL REMAIN Whether through exports or through currency translation, a weaker yen has been a boost for Japanese earnings and therefore for equity returns. The extent of M&A deals pursued by Japanese companies overseas also means the yen/ correlation is expected to persist. CHART 1: VS. YEN/USD Japanese Yen per U.S. Dollar Abe prime minister Boj YCC Boj <o rates MACROECONOMY GEOPOLITICS CENTRAL BANKS ASSET ALLOCATION ASSET CLASSES WEALTH MANAGEMENT INVESTMENT CONCLUSIONS The Japanese economy will definitely require more time to exit deflation, even though wage growth is currently supportive and expected to remain going forward. The BoJ is not expected to change monetary policy before The BoJ is the sole major central bank that directly owns a significant amount of listed equities. Political pressure surrounding prime minister Shinzo Abe has eased recently, meaning that Abenomics has further to go. Yen/Topix correlation is expected to persist. After superior earnings growth in 2017, earnings growth in 2018 is expected to be relatively anemic, while valuations are at a par with Europe. In addition, the yen is expected to appreciate slightly over the coming year. All in all, after a strong rise since end- 2012, Japanese equities could post less appealing returns going forward. We currently favour unhedged FX exposure to Japanese equities to benefit from the yen s defensive features. 1 OF 7

2 HAVE RECOVERED FROM THE CRASH OF 1989 Since the stock market crash of 1989, the has not managed to break above the 1750 level. However, on a total return basis, the has been above its more recent peak of July 2007 since March 2015 (Chart 2). Whereas a look at the price index shows the is still 40% below the level reached on 18 December 1989, in terms of total return it is now just 12% below that level. Before the sell-off on global equity markets of late January and early February this year, the total return for stocks was just 4% below the all-time high. Since mid-december 2012, when Abenomics was launched, the Topix has returned an annualised 12% on average and dividend returns for shareholders in Japan have been quite satisfactory. The average dividend yield in Japan is in line with the US at around 2% (Chart 3). On the surface, Europe is more investor friendly, with a dividend yield close to 4%. But, unlike Europe, buybacks have picked up in Japan since Dividends and buybacks are a long-term supportive factor for Japanese equities. In terms of shareholder returns, Japan has done better than Europe since share buy backs in Japan turned positive in 2016, unlike Europe. This could continue to be a positive factor for Japanese equities. Not only has Japanese equity behaviour normalised relative to other developed equity markets, so has volatility. The implied equity volatility spread relative to Europe (Nikkei 225 vs Euro Stoxx 50) has tightened since last year after having been range bound since The structure of volatility has also converged. The volatility term structure in the Japanese market that was inverted in 2013 is now back to contango (upward sloping term structure), whereas Europe has been in backwardation (downward sloping term structure) since an upsurge in Italy-related political risks. The volatility skew is currently even lower in Japan than in the US or Europe. CHART 2: PRICE INDEX VS. TOTAL RETURN total return price index CHART MONTH FORWARD DIVIDEND YIELDS IN EUROPE, THE US AND JAPAN 7% 6% 5% 4% 3% 2% 1% 0% S&P 500 STOXX Europe 600 Source: PWM&AAMR, Factset, June 2018 Source: PWM-AAMR, Factset, June 2018 THE BANK OF JAPAN IS A KEY FACTOR FOR THE ECONOMY AND FINANCIAL MARKETS Abenomics started out in 2012 with a strong emphasis on structural reforms, the socalled third arrow (the other two being monetary and fiscal stimulus). Japanese officials travelled the world to sell the idea of substantial reform in Japan. But reality has not entirely lived up to the hype. This does not mean that nothing has been achieved, but things are improving only gradually and there have been few big structural shifts. Two significant successes have been the increase in the female participation rate and the improvements in corporate governance. Yet supply-side reforms continue to sound like wishful thinking. Tax cuts of the sort seen at the end of last year in the US look unlikely. Indeed, with the sales tax rate due to be hiked again in 2019, some fiscal consolidation is to be expected. While a fiscal plan unveiled in autumn 2017 aims to bargain tax cuts in exchange for wage growth, there has been no further news on this issue since then. Earnings growth this year in Japan is obviously not benefitting from the fiscal boost that US equities have received. In this environment, BoJ monetary policy (the first arrow), is more than ever the cor- 2 OF 7

3 nerstone of Abenomics. The bold initiatives launched by BoJ governor Haruhiko Kuroda in March 2013 have had major consequences for Japanese assets by triggering significant yen depreciation (although this was a side effect and not an actual policy goal for the BoJ). In particular, the BoJ s yield curve control, introduced in September 2016 with the aim of keeping the 10-year Japanese government bond (JGB) yield close to zero, has been highly successful. Because the BoJ currently owns more than 45% of JGBs outstanding and effective controls the yield curve, the central bank has been able to quietly reduce its annual purchases of JGBs from 80 trillion yen to around 50 trillion yen (Chart 4). CHART 4: BOJ ASSET PURCHASES IN BILLION YEN billion Yen CHARTS 5: BOJ ETF HOLDINGS 70% 60% 50% 40% 30% 20% 10% BOJ holding / ETF total assets TPX, NKI 225, NKI 400 BoJ ETF holdings relative to market cap (rhs) Yearly change Bank of Japan JGB transactions Yearly change ETFs Held Outstanding (rhs) 0% ,0% 4,0% 3,0% 2,0% 1,0% 0,0% billion Yen CHART 6: BOJ S SHARE OF EQUITY INFLOWS 600% 500% 400% 300% 200% 100% 12-month BoJ equity buying relative to Japanese equity inflows 0% % Since September 2016, the BoJ has also been committed to buying 6 trillion yen in Japanese equity ETFs on an annual basis. Unlike JGBs, there is no sign of the BoJ tapering these purchases (Chart 5). Currently, the BoJ accounts for more than 100% of equity inflows into the Japanese market (therefore compensating for foreign investor outflows, Chart 6) and now owns close to 5% of the s market capitalisation. This makes the BoJ the sole major central bank with a direct impact on its domestic equity market. The BoJ s plans to exit quantitative easing have been continually pushed back over the past few years as it has still not reached its 2% inflation target. The risk now is that the BoJ changes course under a new government that sets out new priorities. So far, Shinzo Abe s Liberal Democratic Party (LDP) remains firmly in control, and Haruhiko Kuroda was recently reappointed as governor. But a land sale scandal continues to haunt Abe, who could be forced out of the position of prime minister. A LDP leadership vote will take place in September. Although Abe s approval rating has rebounded recently, should a new LDP leader emerge with a different view of monetary policy, then the current favourable environment for Japanese assets could be jeopardised. THE YEN/ LINK Unsurprisingly, there has been a strong correlation between the yen/usd exchange rate and the since the yen depreciation that followed the launch of quantitative easing in A weaker yen tends to boost exports and inflate profits from overseas operations, leading to higher earnings and therefore higher stock prices. The reverse is also true. Since 2016, yield curve control has lowered the historic correlation between the yen and the. Yet this correlation still exists, as scarce domestic growth has for a long time been pushing Japanese companies to invest abroad. Unsurprisingly, most earnings growth in Japan is driven by exporters. This year is proving to be an exception: base effects mean that big Japanese exporters with US operations that received a boost to earnings growth from US tax cuts in fiscal year 2017 will experience a return to earth in In such an environment, the growth differential between domestic companies and exporters (or those with foreign exposure) has shrunk dramatically in 2018 (Table 1). In the long term, earnings growth for exporters is still expected to be better. Massive yen appreciation could put a spanner in the works, but would likely prove temporary. Our current scenario is for mild yen appreciation over the next 12 months. 3 OF 7

4 Table 1: Earnings growth differential between domestic Japanese companies and exporters Japan Earnings growth % domestic 9.4% 2.7% 5.4% 50% domestic 29.7% 4.3% 12.3% After a small upward revision, 2018 earnings for the are now expected to grow 3.7%. Not only is earnings growth paltry, the breath of that growth is also relatively narrow. The best 25 companies on the account for 119% of the 3.7% earnings growth figure, meaning that, in aggregate, the rest of the should see a decline in earnings. In addition, the earnings prospects for the best companies (Japan Display, Ricoh, Mitsui or Showa Denko) have mainly been driven by massive base effects. Just two companies (Komatsu and Keyence Corporation) out of 25 are on a secular earnings growth path. A second factor that suggests the yen/ correlation will last stems from the buoyancy of Japanese companies overseas M&A activity over the past few years. As outlined in a recent Flash Note ( M&A buoyant so far this year, 1 May 2018), Japanese companies tend to focus on acquisitions outside rather than inside their home market. There are three specific factors that explain the lack of enthusiasm for domestic M&A deals in Japan. The first is the reluctance of Japanese banks to fund domestic M&A. Second, corporate culture is so strong in Japan that it is difficult to integrate rivals in any M&A deal. The third and probably most important factor is the tendency for mergers to lead to staff redundancies. Redundancies go against the implicit social contract in Japan whereby companies do not lay off workers in downturns but in return workers are reticent to demand wage increases in good times. Such a mindset is hard to change and serves to curtail domestic consolidation. This is an area that Abenomics have not really tackled, unlike the efforts made to improve corporate profitability and governance. VIX increase % Broad Effective FX Japan U.S. Dollar per Japanese Yen US 10-year bond total return Broad Effective FX United States Euro per U.S. Dollar Gold (NYM $/ozt) Continuous Euro per Swiss Franc Broad Effective FX Switzerland ICE BofAML US Corporate ICE BofAML Euro Corporate ICE BofAML US High Yield ICE BofAML Euro High Yield S&P GSCI JAPANESE EQUITY EXPOSURE IS BETTER UN- HEDGED The yen is structurally a strong currency that has been artificially weakened by BoJ monetary policy since In cases of market turmoil, the yen tends to appreciate. This has happened during every equity market sell-off over the past 11 years, including in 2016 and at the beginning of this year (Chart 7). All in all, Japanese equities are a good diversifier of equity risk provided the exposure is unhedged, as the yen s role as a safe haven tends to partially offset any equity drawdown. This is a nice feature to have in a portfolio, especially as long-term interest rates are increasing in the US, making bond/equity diversification less compelling in a classic balanced portfolio. JAPAN DOES NOT OFFER A VALUATION DISCOUNT RELATIVE TO OTHER DEVELOPED EQUITY MAR- KETS No matter whether we focus on price-earnings (PE) ratios or enterprise value-to-earnings before interest, taxes, depreciation and amortisation (EV/EBITDA), the valuation of the Japanese market is in line with European levels, at 13.7x 12-month forward earnings and 7.6x 12-month forward EV/EBITDA (Chart 8). Although the sector structure of stock market indexes is different, our analy- CHART 7: AVERAGE CROSS-ASSET RETURNS DURING S&P 500 SELL-OFFS SINCE 2007 Return -10% -5% 0% 5% 10% 85% 4 OF 7

5 sis relies on applying the sector structure of the US market to Japanese sector valuation. This analysis suggests Japanese valuations offer a slight discount but not enough to justify a more bullish view on Japanese equi- CHART 8: 12-MONTH FORWARD EV /EBITDA 11,0 10,5 10,0 9,5 9,0 8,5 8,0 7,5 7,0 6,5 S&P 500 STOXX Europe 600 6, CHART 9: 12-MONTH FORWARD RETURNS ON EQUITY CHART 10: EBIT MARGINS 18% 16% 14% 12% 10% 8% 6% 4% 2% S&P 500 STOXX Europe % 14% 12% 10% 8% 6% 4% S&P 500 STOXX Europe 600 Small Sources: PWM-AAMR, Factset, June % ties in light of anaemic earnings growth. Having avoided the fallout from the euro area sovereign debt crisis, which dragged down ROE momentum in Europe earlier this decade, the average 12-month forward returns on equity (ROE) have improved in Japan (Chart 9), driven by a rise in EBIT (earnings before interest and tax) margins (Chart 10). But over the past two years Europe has made more progress on this front than Japan, with the 3% ROE premium that European equities offer over Japanese ones remaining constant of late. Meanwhile, tax cuts have boosted US corporations ROEs, which are far ahead of those in either Europe or Japan. Japanese small caps have not partaken in margin improvement, with operating margins moving sideways since HALF OF JAPANESE COMPANIES ARE CASH RICH, BUT THESE ARE MAINLY SMALL CAPS The is a common belief in markets that Japanese companies are cash rich and have low to negative financial leverage, which should translate into significant cash returns going forward. At aggregate level, things are actually not that simple. It is still true that Japanese small caps, i.e. domestic companies, have very low financial leverage, but the indebtedness of companies is almost on a par with that of Stoxx Europe 600 companies and above levels for S&P500 companies. In fact, there are major discrepancies across sectors in Japan in terms of financial leverage (Table 2). Financial leverage in the automobile, telecom and industrial sectors in Japan is close to that seen in the same sectors in other developed equity markets. In the case of telecoms, the inclusion of Softbank distorts the leverage picture: without Softbank leverage in the Japanese telecoms sector would be much lower. Half of Japanese companies are net cash, but they are clustered in the small-cap space. Among large caps, names that are net cash can be found predominately in the technology, healthcare, media and personal 5 OF 7

6 CHART 11: 12-MONTH FORWARD NET DEBT OVER EBITDA 3,0 2,5 2,0 1,5 S&P 500 STOXX Europe 600 Small & household goods sectors. Individual cashrich names include Shimano, Nintendo, Makita, Sony, Shiseido, Unicharm and Kao. In an environment where earnings growth is scare and the yen is expected to gradually appreciate, domestic companies, especially small caps, could continue to outperform broad Japanese equity indices. 1,0 0,5 0,0 Table 2: 2018 net debt over EBITDA % of NetDebt/EBITDA Oil & Gas 1.0% 1.15 Chemicals 4.5% 0.72 Basic Resources 1.7% 2.74 Construction & Materials 3.5% 0.19 Industrial Goods & Services 20.0% 1.16 Automobiles & Parts 9.8% 1.46 Food & Beverage 3.9% 0.71 Personal & Household Goods 10.2% Health Care 6.6% Retail 5.0% 0.88 Media 1.2% Travel & Leisure 5.5% 3.04 Telecommunications 5.6% 1.82 Utilities 1.8% 5.03 Banks 6.5% NA Insurance 2.8% NA Real Estate 2.7% 7.08 Financial Services 2.3% 8.24 Technology 5.4% OF 7

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