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Is there cause for Japanese caution?

The Japanese equity market remains, for many investors their highest conviction overweight. But, over the past few days eyebrows have been raised about the level of growth in the region on the back of stalling exports, compounded by worries about the impact of the recent yuan devaluation.


So, considering George Santayana’s famous idiom – “those who cannot remember the past are condemned to repeat it” – what is so different this time around?

“A lot of Japanese companies have historically had cross-share holdings,” Davidson explained. “But the government is less keen on that now, so companies are having to be more transparent about what they are holding, are also in a cost-cutting mindset.

Kevin Doran, Brown Shipley CIO, added: “One of the issues that Japan has had in the past is households ‘over-saving’, which has led to Japan owning the world’s largest pension scheme – the Government Pension Investment Fund, which is $1.3tn in size.

“The GPIF is undergoing an asset allocation switch from bonds into both domestic and international equities, which will not only propel the Nikkei up further but also push the yen lower.”

The other factor in Japan’s favour is that in the eyes of many investors, Japanese equities are one of the few sectors wherein there remains opportunity.

“On an absolute basis Japan is not an expensive market,” said Doran. “The days of Japanese companies trading on 80-100x earnings are gone – the market has gone up in the past year, but it is justified by being off the back of earnings growth rather than multiples expansion.

“Japan is under-owned internationally. As volatility dies down and the Nikkei keeps hitting highs it is an area that could suck investors back in and those flows will provide new impetus for the market.”

Doran says that Japan is his “favourite” geographical equity play, and this conviction accounts for a 10% weighting in his medium-risk portfolio. However, he adds that investors need to be savvy in order to reap the benefits.

He expanded: “Japan has been very successful in devaluing its currency, which has had a positive effect on the equity market in numerical terms, but not in yen terms – all of our Japanese exposure is hedged.

“As the currency has devalued internationally-focused Japanese companies have been able to sell their goods in euros and dollars to overseas markets, which when translated back into yen is a significantly higher number. However for sterling-based investors, while their investments may be going up in yen terms, they are losing out as it is translated back into sterling.”

While China’s ongoing devaluation of the yuan – widely thought to be designed to reclaim export market share – provides a troublesome backdrop, neither Davidson nor Doran are perturbed.

“Japan is used to this world of deflation,” said Davidson. “While China devaluing the yuan is not necessarily good for Japan, it is more insulated than emerging markets will be, which is where the knock-on will be felt.”

Doran added: “There is not a huge amount of overlap in Japanese and Chinese exports – China is more manufacturing-type products, whereas Japan sells higher-quality products, so there is not direct price competition.

“That said, the renminbi significantly reduces in value – 10-15% – then the Bank of Japan might have to respond with more stimulus. So if you are going to do this trade you can be long Japan but must be short the yen.”

So which funds should you be buying to capitalise on this compelling equities story?

“We are overweight there and have been for a couple of years,” said Lowman. “I would continue to be a buyer up to about 25,000 on the Nikkei.”

Lowman gets this exposure via the Neptune Japan Opportunities, Baillie Gifford Japan, Linsell Train Japan and Jupiter Japan Income funds.

“We use a scattergun approach,” he explained. “Some aggressive stockpicking managers, and some income-generators to benefit from rising Japanese yields – 2-2.5% equity yields looks very attractive versus 40 basis points on Japanese government bonds.”