Japanese equities: can the ‘coffin lid’ be lifted?
Yvan Berthoux - 01 November 2017
Over the past 6 years, the Yen-US$ exchange and the Japanese equity market (represented here by the Topix) have moved in a reliably inverse manner. The range of movement has been about 50% greater for the Topix than the currency, meaning that typically two-thirds of equity performance (in US$ terms) was cancelled out by the Yen. This neat relationship broke down earlier this year (figure 1), allowing investors equity gains that were unhindered by currency losses. JP Morgan Global Asset Allocation recently wrote a piece on the Yen/Nikkei correlation breakdown using a flow analysis, emphasizing the fact that purchases of foreign equities by Japanese investors (currency unhedged) were smaller in magnitude relative to the purchases of Japanese equities by foreign investors (currency hedged), and therefore reducing the net impact of the usual Yen down move.
So, can Japanese equity momentum continue? Foreign investors in Japanese equities have often been described as Macro Tourists, jumping in when the macro environment improvs but also jumping out quickly when figures disappoint, resulting in sharp sell-offs. The Topix (figure 2) is now currently flirting with 1,800, defined by Horseman’s portfolio manager Shannon McConaghy as the “Iron Coffin Lid”, a resistance level that the index has failed to break out over the past 25 years. With the Yen depreciation totally reflected in economic performance and with a sequence of surprisingly positive economic indicators, there is a material risk that the jaws of this divergence will snap shut.
The danger in exiting (or shorting) less-liquid Japan equity ETFs at current levels is that potential share buybacks or increased dividends will be realised. As of Q2 2017, cash and deposits for Japanese non-financial companies totalled US$2.3trn, roughly half of Japan’s GDP, for a total market capitalisation of US$5.5trn. For comparison, US non-financial companies totalled US$1.85trn in cash, against a GDP of roughly US$18.5trn and a market cap of US$24trn.
Another interesting potential positive development for Japan’s economy in the long-term is the breakout in shareholder activism. As opposed to the US, Japan’s corporate sector tends to be skewed in favour of employees, at the expense of the shareholders and therefore impacting the price of the companies’ shares. It is known that Japanese companies and their domestic investors have been traditionally resilient on shareholder activism. The corporate governance in Japan has been ripe for revision for some time: Jefferies reported in early 2016 that fewer than 10 percent of companies in the Topix 500 index had an “acceptable” board structure and only 1 percent could be considered “good”.
Our assessment, for now, is that PM Abe has not achieved enough in the corporate governance plane to attract the capital inflow that would liberate the equity market from its 25-year prison sentence. The key issue remains excessive retained earnings, persuading small and medium ‘cash-rich’ enterprises to start funnelling some of it back into the economy. Beware over-optimism.
Figure 1: Yen/US$ exchange rate vs. Topix
Figure 2 : Topix Historical market since 1987
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