On the surface, non-US markets had a relatively uneventful second quarter, with gains slowing a bit following a strong start to the year. The large cap MSCI World ex USA Index advanced a respectable 3.0%, while the MSCI World Small Cap ex USA Index gained a very modest 0.5%. Under the surface however, there was a bit of volatility with solid returns in April and June offset by a weak May. In addition, the local markets were better than they appeared, but a strong US dollar hurt reported returns by about 2%.
Regional returns were mostly muted with Europe and Asia offsetting some weakness in North America. Within Asia, Japan was the best market despite a weak yen, while Hong Kong sold off as China’s reopening disappointed. Europe was mixed with some areas of strength such as Denmark and Italy, while the Nordics were weak, led by declines in Sweden. Sector returns also varied widely. Financials rebounded after last quarter’s decline, joined by Utilities and Information Technology. Materials, Communication Services, and Real Estate were weak and may be implying concerns that interest rates will remain higher for longer, which has been our view for some time.
One region seeing some positive change and starting to attract investor interest is Japan. We have spoken piecemeal about our bullish view in the past, but this quarter will lay out what we see as the bullish case for the country’s equity market.
Despite the common perception as a low growth market, since 2013, operating earnings growth for Japan (TOPIX) have outpaced those of other developed markets, including the US (S&P 500). The stock market has not done as well, but that is because of multiple expansion elsewhere and not slow earnings growth. Further, given that earnings are reported nominally, and Japan’s inflation has been lower than other developed markets (e.g., since 1995 just 0.3%/year in Japan versus 2.5%/year in US), the real earnings growth in Japan has been underappreciated.
There is a positive macroeconomic case to be made as well. Long an area of concern (and still far from perfect) Japanese corporate governance, and in particular the focus on shareholder returns, is undergoing rapid improvement. The government and stock exchange are actually pushing companies to improve returns, which is showing up in rapidly growing buybacks and dividends. Unlike in some markets, these shareholder returns come from retained earnings and not through increased leverage. In fact, the shareholder yield on the TOPIX is now equivalent to that in the US or EU, but arguably with significantly more upside potential. Meanwhile, the central bank is running the loosest monetary policy of any major market. We expect some tightening this year, but it will remain very accommodative relative to others. At the same time, after so long in a deflationary funk, a bit of inflation will (at least initially) be seen very positively, driving wage increases to workers while providing cover for companies to increase prices, in some cases for the first time in decades. This policy has led to a weaker yen which has made Japan’s production costs incredibly competitive with peers just as global supply chains are diversifying.
The Japanese market currently trades in-line with its 10-year average valuation, indicating that these positive changes are far from priced in. For example, all the flows that went into Japan during the Abenomics period had subsequently exited by the end of last quarter, so despite record foreign buying the last few months there is plenty of room to run. Finally, and most bullishly, Japan is massively underinvested in their own equity market versus overseas equities and domestic bonds. If inflation makes bonds less attractive and money returns from overseas, the flow into Japanese equities would be a huge tailwind for equity prices.
There are plenty of bearish arguments which could also be made, the most salient of which is that Japan traditionally has been highly correlated with global growth and susceptible to recessions. On balance though, we find the market quite attractive. Our core investment approach remains focused on bottom-up stock picking, finding specific businesses with strong fundamentals and balance sheets able to weather difficult markets. Japan offers a large number of these opportunities, but it is still best owned as part of a diversified, well-chosen, stock-specific portfolio.