As Japan’s stock index hit a 33-year high in May, GAM Investments’ Ernst Glanzmann highlights some of the drivers, including a promising earnings season, reforms led by the Tokyo Stock Exchange and the global economic situation.
24 May 2023
Ernst Glanzmann - Japan Leaders
Japan has become quite topical in the press, with publications reporting that Japan’s stock index hit a 33-year high in May. What is driving the market?
One of the main drivers is a better than expected earnings season. Year-on-year net profits, (excluding Softbank, which we view as an idiosyncratic event) are up 13%, while quarter-on-quarter numbers have also been slightly higher. Moreover, a number of companies have been announcing share buybacks, some of more than 10% of the outstanding shares, which is exciting for investors. There is also much interest in the low price/earnings ratio for the Topix Index.
Another key driver is the reforms proposed by the Tokyo Stock Exchange, which focus on improving the price-to-book ratio and cost of capital of primary listed companies. The committee responsible believes that the concept of cost of capital is not well known among corporate managers in Japan and so there needs to be education and improvement, hopefully leading to a better return on equity, profitability, and price-to-book ratios down the road. While the recommendations of the Tokyo Stock Exchange are not hard rules, their advice, combined with the support of Prime Minister Kishida, offers guidance.
In our view, the story going forward is that there will be strong efforts to improve the efficiencies of balance sheets, as well as profitability and operational efficiency in the next few years. This will be a slow process but should be positive for the equity market.
Most of the return on equity improvement we have seen in the last 20 years in Japan is based on the operating profit margin. The asset efficiency ratio has been the main drag on improving the return on equity; once corporates start to work on their net cash positions, there should be a meaningful improvement for companies on their return on equity and this could eventually lead to better price-to-book ratios or a lower cost of capital for shareholders.
We are also positive about the turning points in the rest of the world. Japan still relies heavily on the US economic situation. Looking at the US ISM Purchasing Managers Index, as well as the year-on-year change of US new orders for the manufacturing durables (excluding transport) sector, we believe we are close to a turning point and going forward in the next few months we could expect this to be shown more clearly. The car industry in the US is recouping the issues it had with procuring key electronics parts and is now producing and selling more cars. There is a clear improvement in the demand that is also positive for several companies listed on the Tokyo Stock Exchange.
From a top-down point of view, semiconductor sales are still down year-on-year but we believe we will slowly see improvements. The main drag on the three-month average has been Asia Pacific, which has started to show signs of reaching the bottom; we would expect more positive news going into the summer. We also believe that by then we will have reached a turning point in Japanese robotics.
Regarding operating profit margins of listed companies in Japan, especially in the manufacturing space, we will have to pay attention to the input prices. Looking at the Nikkei 42 commodity prices in Japan, input price pressure should start to ease, and this will have a positive impact on margins going forward. We saw the same with freight rates. This is good news and should be reflected slowly but steadily in the future results as transportation costs are less harmful for operating margins than they were previously.
Since the end of Covid, we have seen tourism bouncing back in Japan. Foreign visits to Japan are getting close to the levels last seen before Covid hit. Total employee income in Japan is growing at close to 3% which should be a supporting factor for private consumption growth.
It seems South Korea and Japan are becoming more closely aligned with the tension between the US and China. Prime Minister Kishida recently invited semiconductor leaders to Tokyo for discussions implying that Japan is willing to accept more semiconductor-related factories to serve the world ex-China with machinery. We expect Japan to position itself as a favourable destination to benefit from the global onshoring trend, which in turn will be positive for Japanese equities overall.
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