Headlines in the financial press this week have concentrated on the global market sell-off in stocks and the corresponding rally in global bond markets. The universal fear is that this is a reprise of the global contagion of last April-May. That sudden market fall seemed to come out of nowhere and this one has caught traders on the hop in much the same way. However, there are significant differences between the two events.
Last year the sell-off was concentrated in one particular area, the high-risk stocks and markets, making it what we call an “alpha correction”. But this one has been more of a “beta correction” in that, instead of just hitting the best-performing parts of the market, it has hit all markets, all sectors and all stocks in the same way. This makes a big difference. When everything falls, the cheaper, less volatile parts of the market retain their relative appeal: investors can therefore respond to the whole thing by rotating out of risky assets and into more defensive ones. It doesn’t take long in this kind of case for the parts of the global market that offer value to find a floor to rebuild from and then to rally. This is what I expect to see happening very soon in Japan, which I think is currently one of the best opportunities around for investors.
Investing in Japan: Topix hits new high
Let’s not forget that the Topix broke through to a new high last week on what was ostensibly bad news for the market – the Bank of Japan’s (BoJ) decision to double interest rates from 0.25% to 0.5%, a new nine-year high. The rate rise was bad news for a variety of reasons. There were no real economic grounds for it (even the Bank of Japan Governor, Fukui, has admitted it is likely that core inflation may go negative again in the next few months). It was clearly a political decision related, perhaps, to the fact that parliamentary elections are coming up, so this was pretty much the last time for a while that a hike was going to be politically acceptable.
Just before the rate decision was announced, the Topix was one point below its April high and teetering on the edge of either seeing a sharp technical correction, or breaking to a new 15-year high, depending – so it seemed – on what the BoJ decided. But when the news of the hike filtered through, to everyone’s surprise the market didn’t fall. The bad news was ignored.
Instead of seeing the BoJ lifting rates to a near ten-year high as an almost-disastrous policy blunder likely to tip an already-fragile economy back into recession,
the market decided to see it as an encouraging sign that rates now won’t move again for 18 months. This is despite the fact that deflation has not been beaten and there are signs the domestic economy is again running out of puff. Also of interest is that this week’s global panic hasn’t hit Japan particularly hard either. Yes, the index fell more than 5% in the first two days, but it then rallied 2% through most of Wednesday’s session.
So what does this tell us? I think it tells us that the mindset of investors in Japan is beginning to change. There are many ways to categorise a bull market, but one definition is that it’s the type of market where all news is seen as good news.
If the Topix had failed last week – falling as the rate decision was announced – it would have been the sixth time it had failed to break above the 1,750 level, and those who claim that all the recent movement in the market has added up to no more than a few big bear market rallies could have been considered to have had a point. But it didn’t fail, and to me that says the consolidation of 2006 is over and the bull market in Japan is back.
Markets that break out after long consolidations tend to make big gains; those that do so on bad news as well tend to fly. Within eight months of the August 2005 breakout, for example, the Topix had gained 46.5%. The similarities between then and last week’s events are compelling. Then there had been a long consolidation and a decisive break on a bad news day, as it became clear that Prime Minister Koizumi’s reformist agenda had failed to reform the post office system. This time we have seen the same sort of lengthy consolidation followed by a break-out on bad news.
The big question now is whether this is anything more than a technical timing issue, or whether there are fundamentals there to back up a big move. At first glance, the economic environment doesn’t look great. There is that rather unhelpful interest-rate rise for starters, although, as I’ve said, that particular cloud does come with a silver lining: we can be fairly certain there won’t be any more hikes for quite some time. The bond market liked that idea and Japan Government Bonds (JGBs) went up sharply on the news.
In fact, ten-year JGB yields, which are now 1.67%, have been falling steadily since last May’s 2% peak (prices rise as yields fall). Falling long-bond yields tend to be good for equity market valuations, though they do also often reflect a wariness about growth prospects.
Last time around, in 2005, the bank sector led the recovery story as the market could finally see loan growth moving into positive territory after nearly ten years of credit crunch. That the yen was weakening too helped the export sector to climb on the bandwagon. Pretty soon, every sector in the market was getting in on the action. Pride of place, however, went to the smaller stock indices as domestic investors piled in.
This time, the smaller stock indices, like the TSE second section and the TSE Mothers index, are barely above their nine-month averages. While their potential looks fantastic from here, they have hardly been leading the latest charge. Lagging just as much has been the banking sector. Household name exporting blue chips have also underwhelmed. Instead, three distinct but interwoven stories have been leading the market higher. First, there’s the Chinese-related metals story that has been behind big moves in steel, stainless steel and nickel plays, as well as the shipping and trading firms that move their products. This story will remain a driver for now, but it is vulnerable to a US-inspired slowdown in demand. The other two legs of this market are less volatile, but much more robust. On the one hand, the market has at last discovered the virtues of dividend yields. Most stocks still have pretty low payout ratios by Western standards, but that has largely been down to the tax treatment holding firms used to receive. This has changed, and any company with a decently low price to earnings ratio (PER) can now be expected to start raising their dividend payout ratios towards Western norms.
With profit margins at an all-time high and the stockmarket still 40% below its December 1989 peak, even after the last four years of rising prices, the Topix index PER has remained below 20 times. This means that even though dividend yields are around 1% (poor recompense you might think compared to long bond yields of around 1.7%) dividends are set to rise. With the earnings yield at 5% or more for the last half decade, the scene is set for a significant re-allocation of domestic funds in favour of equities. If payout ratios approach 40%, yields may double.
The final and, to my mind, real driver of the Japan story is property. According to the official data, commercial land in Japan is now priced lower than in 1974, which must make it the cheapest commodity in the world. Anecdotally, however, we already know that prices are surging. Land valuations were being held back by a credit crunch. Unable to borrow, prospective redevelopers could only watch as the few cash buyers snapped up property portfolios yielding high single, or even double-digit, gross yields. But now things are starting to move again. Eventually, Japan’s long credit crunch will truly be over and prices will rise properly. There is still room for growth in the real-estate stocks, but on top of that there are a myriad of stocks and sectors where re-valued land asset holdings could see significant uplift to net asset value, or even redevelopment profits – think railways, logistics, theatres, heavy industry and so on.
So, economic growth may not be up to much, but Japan now has a reliable monetary policy outlook. It’s cheap compared with the past and bonds and land prices are on the cusp of a massive upward re-rating, while payout ratios have the scope to rise significantly across the board. Improvements in fundamental values have kept track with the 133% that the Topix has gained since 2003, such that the PER hasn’t departed from a narrow
15 to 20 times band in all that time. Over time in most major markets, earnings yields end up trading on parity with bond yields. In Japan, earnings yield 5.3% – three times what bonds do. There’s still a long way to go.
Get into the Japanese market: invest in an ETF
The easiest and cheapest way to gain a broad exposure to the Japanese market is to invest in a Japanese exchange-traded fund, such as the iShares MSCI Japan (EWJ). The ETF carries a total expense ratio of just 0.59% and its performance is more than competitive when you consider that the majority of fund managers fail to beat the index. Investing in funds is also a good way to gain exposure to Japan, and Justin Urquhart Stewart of Seven Investment Management recommends looking for broadly based funds with recovery possibilities, such as Legg Mason Japanese Equity fund. The £154m fund was the worst-performing British-based unit trust last year, falling 50.56%, says Lipper. But Urquhart Stewart insists the fund is well managed and will “bounce back”. It invests in small-caps with high growth potential, and in contrast to its peers has a large weighting in “New Japan” stocks, such as retailer Don Quijote and pharmaceutical group Otsuka.
On the other end of the scale, Axa Framlington has been the best-performing Japanese fund over the past three years, returning 69.7%. Manager Anja Balfour has weighted the fund towards large-cap stocks, with a focus on financials. Aim-listed Japanese Residential Investment Company (JRIC), which listed last year, is a way to play the Japanese property market. The firm plans to build a £330m portfolio of residential property and is targeting a 6% dividend yield, says Investors Chronicle. The other UK-listed Japanese property play is the Prospect Epicure J-Reit Value Fund (PEJR), which has a heavier weighting in commercial property.