Equity valuations to increase as deflation fades

In October, the Japanese stock market rallied following favourable economic indicators, a depreciation of the yen against the US dollar, expectations regarding economic policies following the Lower House election and increasing corporate profit growth. The Nikkei 225 closed the month at 22,011.6, up 8.1% MoM, while the TOPIX ended the month at 1,766.0, up 5.5% MoM.

Monthly Fund Commentary
24 Nov 2017

In October, the Japanese stock market rallied following favourable economic indicators, a depreciation of the yen against the US dollar, expectations regarding economic policies following the Lower House election and increasing corporate profit growth. The Nikkei 225 closed the month at 22,011.6, up 8.1% MoM, while the TOPIX ended the month at 1,766.0, up 5.5% MoM.

On 2nd October, BoJ’s quarterly economic survey “Tankan” revealed improved business sentiments. At the same time, the US ISM manufacturing index (PMI), reached a 13 year high of 60.8 in September, beating market consensus forecasts. Moreover, on 10th October, the IMF revised its global growth forecast for 2017 from initially 3.5% up to 3.6%.

Political uncertainty in Japan declined as the ruling coalition gained more than two thirds of the seats in the Lower House election held on 22nd October. The passing of the FY18 budget by the US Senate buoyed expectations about reforms in the US tax system, leading to the depreciation of the yen against the US dollar and a subsequent rally of the Japanese market. The market further gained support from the easing of geopolitical risk associated with North Korea.

Throughout the month, the Nikkei 225 rose for 16 straight business days from 2nd October through to the 24th October. Alongside continuous surges of the US and the European markets, the Nikkei 225 reached its 22,000 level on 27th October for the first time since July 1996. Foreign investors were the primary driver behind this rally.

According to Nomura, an Asia-based financial services group, there were large net purchases of cash stocks and stock futures throughout the first three weeks of October totalling JPY 2.7 trillion, largely surpassing the net sales of JPY 2.2 trillion throughout the entire calendar year 2016. The US dollar started the month at 112.5 against the yen, lending at 113.6. At the same time, WTI crude oil closed the month at 54.4 $/bbl from an initial 51.7 $/bbl at the beginning of the month.

In terms of sector performance, all sectors of the TSE 33 sectors gained. The five best performers were non-ferrous metals, electricals, metal products, machinery and glass & ceramics, while the five worst performers were mining, marine transportation, oil, air transportation and steel.

The net asset value per unit for the Nippon Growth (UCITS) Fund on a Japanese yen basis as of 31 October 2017 rose 5.2% compared with that of 29 September, while the TOPIX went up 5.5% during the same period. The Fund put no new names into the portfolio with no stocks sold out.

The Japanese economy is currently showing a steady and sound recovery. Industrial production decreased 1.1% MoM in September, after having returned strong numbers in August (up 2.0% MoM). Overall, industrial production rose 0.4% QoQ in Q3. The government forecasts that industrial production in October will rise 4.7% MoM and decline 0.9% MoM in November. It looks as if production activities are gaining strong momentum, on a monthly basis however, a patchy trend is observed.

The reporting season for corporate profits in Q2 FY217 is currently in progress. According to the Nikkei newspaper (as of 8 November), 64.7% of all listed companies (excluding financials and new markets) announced recurring profits for H1 FY2017, up 22.8% YoY in aggregate. The companies forecast that recurring profits for FY2017 will rise 11.5% YoY. Judging from recent economic data and currency movements, these forecasts appear to be conservative and leave room for an upward revision.

Nationwide core CPI (excluding fresh food) has continuously increased throughout 2017 (Jan.: 0.1% YoY; Apr.: 0.3% YoY; Jul.:0.5% YoY; Sep.: 0.7% YoY). Core CPI is likely to rise up to 1% within a couple of quarters as public service and energy related costs are expected to increase from now on.

By the end of the year, Prime Minister Abe is expected to announce a JPY 2 trillion supplementary budget for FY2017. He recently also called business leaders to make an effort to increase wages by 3% at next year’s pay negotiations. The above mentioned factors may lead investors to believe that the economy is returning to normal, with deflation being overcome. In this regard, equity valuations may shift from a comparatively low level under a deflationary environment (i.e. PER 10-15x) to valuations reflecting a stabilising economy (PER 15- 20x). The paradox is, that the higher the market goes, the cheaper it appears to investors. Based on Nomura’s most recent valuation report, PERs for large caps for FY2018 still remain cheap at 15.1x. It is expected that economic sensitive stocks should lead a market rally in 2018, with the TOPIX likely to approach 2,400 by year end.

The Fund is increasing its allocation to the machinery and IT service sectors with the conviction that capex will expand due to the increasingly serious labour shortage and potential capacity constraints. Cyclical sectors such as steel, nonferrous metals, and chemical together with energy are also targeted for higher exposure. The Fund retains a positive stance towards banks and trading companies, while defensive sectors such as foods, pharmaceuticals and utilities are avoided.