What will it take for Japanese equities to outperform next year?
T he underperformance of Japanese stocks since the mid-1990s has been largely driven by multiple contraction, rather than weak earnings-per-share growth. Japanese equities currently trade at book value, compared with 2.2 times book in the U.S. On a forward P/E basis, Japanese stocks trade at 12 times next year’s earnings, in line with the global average. That said, Japanese corporate profit margins are only half of what they are globally, suggesting some scope for efficiency gains among Japanese firms in the years ahead.
While valuations are compelling in the near term, Japanese stocks are likely to be driven by monetary policy. Although it is doubtful that Shinzo Abe – who is widely expected to be elected as the next Prime Minster on December 16 – will be able to compel the Bank of Japan (BoJ) to adopt a 3% inflation target, it is possible that he will be able to strike an accord with the BoJ that will lead to more aggressive quantitative easing.
This, together with the fact that after two painful decades, the corporate deleveraging cycle in Japan is drawing to a close and property prices have started to stabilize, suggests that the era of deflation may also be coming to an end. If so, real interest rates in Japan, which are the highest among the major developed economies, are likely to decline, giving Japanese assets a welcome boost.
Bottom Line: Although valuations are compelling, the big swing factor for Japanese equities will be the extent to which the BoJ pursues aggressive monetary policy. Stay tuned.