Japanese markets have certainly seen a positive start to 2018 with equities hitting their highest levels since the 1990s in the first week of the year[1]. This has been driven by a number of factors, but none more so than the improving economic backdrop in the region. With this current market sentiment in mind, we have taken stock of the surrounding macroeconomic environment, the potential risks to future success and how they impact our outlook for the rest of the year.
Macro backdrop
The most significant development in 2017 was the result of the so-called ‘snap’ election held in October, which strengthened prime minister Shinzo Abe’s position and mandated the continuation of his economic policy.
With a helping hand from Abenomics, the Japanese economy has seen gradual improvements in unemployment, the labour market and GDP growth since its inception. If we continue to see a tighter job market this should translate into growth in wages and inflation, as well as increased consumption and a further strengthening of the domestic economy.
The government has been putting pressure on local companies to raise wages, for now, however, wage growth has mainly fed through to part-time workers. With commodity prices stabilising and a tighter labour market pushing wage pressures through to other parts of the working population, there should ultimately be some momentum in inflation, providing a further boost to domestic consumption and the economy at large.
Is it still a good time to invest in Japanese equities?
Despite recent strong momentum for the Japanese equity market, we believe that valuations are still relatively attractive when compared to other markets, such as the US, and are in line with historical pricing. When considering the performance of Japan relative to the global market in USD, the country’s equities stopped underperforming around 2014.
In addition, a rising US interest rate environment has historically been supportive for Japanese equities and this bodes well given the Fed’s upward trajectory as highlighted by the 0.25% rise in December. Rate increases tend to be associated with periods of strong economic growth and should the US economy continue its growth momentum, especially considering the Trump administration’s planned stimulus, Japanese equities should benefit.
Where do the risks lie?
Despite the positive story surrounding the Japanese economy at large, we do caution that risks still lurk which could potentially disturb the bullish trend for equities. One risk to consider is a slowdown in its closest export economy, China. Any weakness in the Chinese economy could well have a significant impact on Japan’s exporters and the global economy as a whole. Alongside the risk posed by a slowdown in China, the ongoing geopolitical turmoil in North Korea carries a significant tail risk, due to its geographic proximity and political allegiance.
A broader risk is public debt. Abenomics has generated high government debt, as well as a large primary deficit. The Abe administration’s pledge to turn the deficit into a surplus by fiscal year 2020 remains optimistic in our view.
Conclusion
While the overall outlook for Japanese equities remains positive, investors should consider a prudent investment approach given the current uncertain market and geopolitical risks.
From our point of view, that would be one that provides good exposure to Japanese equity markets within a strategy that vigilantly manages forward risks and provides downside protection in the event of market stress episodes.
[1] Source: https://www.ft.com/content/28745e58-6cca-3ca2-b666-33563f033995
Gaël Combes is a fundamental analyst, and Maria Musiela, investment specialist on Unigestion’s Uni-Global Equities Japan fund
