Japan's stock market hit record highs last month, so investors have high hopes it can be another bumper year for the country's domestic index. Nevertheless, its first interest rate rise in 17 years complicates the outlook for investors, as I discussed in a recent article.
What often gets overlooked in discussions of "record highs" is that certain individual stocks are driving these index increases. In this case, companies like Toyota Motor (7203) have posted explosive growth, with shares up nearly 100% over one year. Because of the weaker currency, it's been a boom time for exporters like Toyota, which makes up the largest part of the Morningstar Japan Index, which itself holds more than 1,000 stocks.
Morningstar analysts cover 69 of those Tokyo-listed stocks and 24 are rated as 4- or 5-Star stocks, which screen as undervalued. Just two, Nissan Motor Company (7201) and chemicals firm KOSE (4922) are considered significantly undervalued, according to our metrics. That 24 remain undervalued may seem surprising given the strength of Japan's market rally. The table below indicates which sectors are overvalued or undervalued: consumer defensive, industrials and technology are well represented in the 4-star cohort.
The quarterly Tankan survey has just been released by the Bank of the Japan, and it showed services in good health, helped by the lure of cheap currency for tourists; but manufacturing sector growth, while still strong (and better than Europe), has started to flag.
The yen actually fell further after the rate rise, which goes against basic economics, which would normally posit that tighter monetary policy pushes up currencies. But there are a lot of moving parts in the global economy this year. A lot depends on when the Federal Reserve starts cutting rates, especially as June now looks less likely. Many experts, such as Columbia Threadneedle chief economist Steven Bell, expect the Bank of Japan to take "baby steps" in raising interest rates.
What's Going on in Japan's Economy?
• Tourism is booming;
• Services growth is strong;
• The yen remains at multi-decade lows;
• Japan avoided a technical recession – just;
• Large-cap stocks have performed well.
Can Japan's Small Cap Stocks Catch Up?
An appreciating yen could still disrupt the gains of the exporting stocks. Would small- and mid-cap stocks, which have lagged their larger peers, then catch up? That's the view of Joe Bauernfreund, who runs the manager of the AVI Japan Opportunity (AJOT) trust.
He argues corporate governance reforms have been led by the larger capitalised stocks, with smaller companies previously under "no pressure to do a better job". Now they have to focus more sharply on shareholder returns and profitability. But that still leaves a raft of underappreciated companies in Japan, he says, many of which have attracted the interest of the burgeoning private equity sector in Tokyo.
Morningstar analyst Lorraine Tan argues that, when they come, rate rises will favour financial services because of net interest margins. But the gains of inflation and positive interest rates can be more broadly shared – and even if the yen rises, this will not make a big difference to returns seen by foreign investors.
"We think the main reason overseas investors can be long-term positive on Japan is the return of inflation will provide a boost to spending and drive capital reinvestment," Tan says.
"Its decades-long deflation discouraged Japanese companies from reinvesting domestically and also saw house prices slip. Now that there appears to be some prospect of rising prices, we hope that this will lead to a sustained changed mindset towards domestic investment, and that this will lead to increased consumption.
"However, should the yen appreciate as quickly as it fell, some of these drivers could be diminished. We think overseas investors, however, should be hedged in that regard as a strengthening yen should help counter a possible slip in share prices."
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