It’s time to revisit Japan

The Nikkei 225 Index suffered a 12.1% decline in local currency terms and a 8.3% fall in ringgit terms in 2018. 

The Japanese equity market benchmark had also suffered a rough start to 2019, but has retraced the lost ground on attractive valuations.

Based on consensus, earnings are forecast to grow by 3.7% and 12.3% in financial year 2019 (FY19) and FY20 (ending in March 2019 and March 2020) respectively.

Forward price-earnings (PE) ratio for 2019 is looking attractive at 14.5 times. The 2020’s forward PE ratio is even lower at 13.1 times.

The last time the Nikkei 225 Index was this cheap was between 2011 and 2013.

In 2011, Japan was hit by the Tohoku earthquake which subsequently led to the Fukushima Daiichi Nuclear disaster, tipping Japan into a recession due to a fall in consumer activity and lower production capacity.

To make matters worse, China’s double-digit economic growth eased to a high singledigit growth, thus impacting the region’s economic growth negatively. Despite recovering well in the third quarter of 2011 (3Q11), Japan’s economy faltered again in 2012 — paving the way for conservative politician Shinzo Abe to come in and pledge to boost the country’s economy.

Earnings for the Nikkei 225 Index fell 25% year-on-year (YoY) in FY12. The Nikkei 225 Index returned a loss of 17.3% in local currency in 2011, while the PE ratio was at a low of 13.5 times before re-adjusting upwards to 22 times due to the huge fall in earnings.

The situation is not that different today compared to six to seven years ago.

Similar to 2011, Japan suffered an earthquake in 2018, albeit a weaker one. Subsequently, its GDP growth fell in 3Q18, recording 2.5% fall quarter-on-quarter seasonally adjusted annualised growth.

Technically, if the 4Q18 GDP release turns out to be negative once more, Japan will be in a recession, similar to 2011 too.

Economists are expecting slow growth in China, although it is much less drastic compared to seven years ago.

If we assume earnings would register a -25% growth this year, prices could fall by at least 10%, bringing us to a PE ratio of 18 times.

It is very possible that investors have factored in such a scenario, given where valuations are today. This will give us lower downside as compared to other global markets.

We have a conservative growth scenario where the Nikkei 225 records a 5% earnings growth for both FY19 and FY20, a forecast that is lower than consensus. In this case, the index could rise 25% to end up at 25,000, giving us a forward PE ratio of 17 times.

To look at which scenario is more probable, we examine a few macroeconomic factors.

Due to the labour market crunch in Japan, firms are almost certain to push for higher capital expenditure to maintain productivity.

In the Tankan survey, enterprises forecast higher investment growth in December 2018, which appears to be on an uptrend too.

Corporate metrics like companies’ margins are looking rather healthy with profit margin are on an uptrend as well.

Japanese companies have become more efficient over the past seven years, which is in line with the Abe administration’s objective of improving shareholder friendliness of corporate Japan.

With the Liberal Democratic Party holding the majority of the House of Representatives in Japan, its President Abe is set to be the longest serving president in Japan.

The Abenomics is set to continue and the Bank of Japan is likely to continue its accommodative monetary policy to re-introduce inflation into Japan’s economy.

Hence based on valuations, we believe Japan’s equity market offers an attractive opportunity based on its risks and reward.