While equity markets in North America experienced a difficult October, Japan’s equity markets may prove an attractive alternative given their relatively dampened valuations and companies’ historically high profit margins.

“Part of the reason why we’ve started to move on our preference to upgrade Japanese equities has been that we are starting to see earnings on the upside in Japan,” says Angus Sippe, a portfolio manager at Schroders Investment Management Ltd. “We’re starting to see a bit better growth than we have previously. It’s an early-stage sign of earnings recovery, but also, at this point, you have quite attractive relative valuations on a global basis.”

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However, Japanese equities will continue to be beholden to movements in the yen, says Sippe, noting many global investors have shied away from Japan because of its currency’s volatility. As well, the underlying sector composition of Japan’s market hasn’t been favourable for a technology-led growth environment. The market is dominated by financials and technology companies aren’t seeing the same boons as their counterparts around the world, he adds.

“We’re not taking any sector bets within our Japanese exposures,” says Sippe. “We’re taking the full index at this point. Part of that is because, from a global perspective, we’re not out of the woods with the U.S. trade spats. And Japan being quite an export-led market could still suffer from U.S. policy on trade.” However, Sippe does believe the Japanese automobile sector is the riskiest area for now.

In particular, companies with strong ties to China’s economy are seeing more compression than others, says Kenichi Amaki, a portfolio manager at Matthews Asia. Headlines about China’s trade troubles with the U.S. are exacerbating those worries, he adds. “[Japanese] consumer staple companies like cosmetics [and] toiletries have seen really rapid growth through their China business and those have strong demand, but I think there is a perception that the Chinese economy is slowing down very rapidly. It is to a certain extent, but not too much.”

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A further reason for the country’s muted valuations is that Japan’s markets offer more liquidity than other international markets, resulting in selloffs when times start to get tough for stocks around the world, says Amaki. “That also means it creates opportunities for longer-term-oriented investors to seize that opportunity to build long-term positions when those volatility events happen.”

Amaki has also heard concerns about Japan’s central bank purchasing exchange-traded funds in the market, with some projecting these purchases are pushing valuations higher than they would otherwise be. However, the buying, so far, hasn’t moved the needle to any visible degree, he says.

“I think that earnings growth story is still under-appreciated. Profit margins in Japan have improved substantially. Now there’s a cyclical component to it and we’ve been in a rather good part of the economic cycle, so that’s helping. But it’s also structurally improving quite a bit. And I think that governance side, that emphasis on governance, has impacted how corporate managers look at their overall business portfolio, and they feel a really strong sense of urgency to improve their return-on-equity numbers.”

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Copyright © 2019 Transcontinental Media G.P. Originally published on benefitscanada.com

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