JAPAN is one of our top equity market picks. Within the market, Japanese value stocks remain attractive and stand to benefit from the ongoing shift in macro backdrop.
As the drumbeat of a recession gets louder, we find Japan to be one of the few markets we like. Japan value stocks, in particular, are a bright spot within the market and have delivered strong performance over the past few decades.
Japan value stocks stand to benefit from a potential Bank of Japan (BOJ) tightening and the ongoing decade-high inflation. Japanese banks, a major exposure within the value factor, are likely more resilient to banking issues seen in the West.
Japan, our top equity market pick
As the drumbeat of a recession gets louder and equity drivers are running scarce, we find Japan to be one of the few markets still supported by a confluence of positive factors.
Japanese equities remain underpinned by a strong reopening tailwind and robust domestic spending. We expect a comparatively better economic outlook in Japan than developed market (DM) peers, which supports the relative performance of the region’s equities.
Corporate balance sheets for Japanese companies are also strong as compared to historical levels and DM peers. On aggregate, companies are entering the global slowdown with historically high, cash-rich balance sheets which can be deployed to defend operating performance.
Valuations are also attractive, with the region trading at a wide discount to their long-term average. This provides a wide margin of safety in the event of a recession.
Lastly, with our view of a rebound in the yen relative to broad currencies, we also see additional cushion from currency gains for foreign investors.
Reasons why Japan value has the advantage
The Japan value stocks universe (gauged by the MSCI Japan Value Index) is dominated by a heavy concentration in three sectors – industrials, consumer discretionary, and financials – all of which have high double-digit weights each.
There are several sectoral heavyweights in the index. Within the industrials sector, there are conglomerates like Hitachi and trading giants like Mitsubishi Corporation and Mitsui and Co. Within the consumer discretionary sector, there are global automobile leaders such as Toyota and Honda.
Lastly, within the financials sector are Japanese banking giants like Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and the Mizuho Financial Group.
The Japan growth factor (gauged by the MSCI Japan Growth Index), on the other hand, has a more balanced sectoral exposure. The large allocations are split across the IT, industrials, consumer discretionary, healthcare, and consumer staples sectors, each with a double-digit weight.
Within the IT sector, there is prominent exposure to electronics and semiconductor companies like Keyence and Tokyo Electron.
Within the consumer discretionary sector are allocations to global conglomerates like Sony Group and Fast Retailing. Within the industrials sector are global manufacturers like Daikin Industries. Lastly, within the healthcare sector are pharmaceutical giants like Daiichi Sankyo.
Last year, Japanese value stocks were one of the rare positive-returning segments across the global equity market. Japanese value (gauged by the MSCI Japan Value Index) returned five per cent in 2022 (in local currency terms), defying the turbulent equity storm that has sunk most segments of the market, including Japanese growth (gauged by the MSCI Japan Growth Index) which fell by 18 per cent.
Unlike the broader global value stocks, which have chronically underperformed their growth counterpart over the past few decades, Japanese value stocks are the complete opposite.
Over the past 30 years, Japanese value stocks have gained over 110 per cent, beating growth stocks as well as the broader MSCI Japan Index. Similar to value stocks in other regions, the outperformance of Japan value can be explained by macro factors such as rising inflation levels, tighter monetary policy, and higher yields (see related articles).
However, Japan value is more advantageous than its regional peers. Unlike global central banks, the BOJ has more room to tighten policy and the unwinding of YCC will likely bring greater upside to Japanese bond yields, supporting value outperformance.
In short, while the rest of the world is looking toward the end of rate hikes, Japan’s hike may be on the verge of beginning.
Furthermore, given a late re-opening, Japan’s inflation has lagged behind most DMs. We think this prolongs the support for inflation-sensitive sectors, which are more prominent within Japan value, and maintains pressure on the BOJ to tighten policy.
Lastly, unlike Western banks, Japanese banks (a heavyweight in Japan value) have strong capital buffers and stickier deposits.
The BOJ also maintains an upward-sloping yield curve which can buffer net interest margins.