The Factory Daily Letter

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The BOJ’s diverging monetary policy provides a favourable backdrop for equities

Since our last update on Japan, the favourable factors for Japanese equities have been maintained or even improved. Despite the good relative performance of the Japanese index since the beginning of the year, we believe that more upside persists and that buying opportunities have emerged in the cyclical sectors which could also offer a cheap way to play the (gradual) reopening of China while offering a hedge in an environment marked by persistent high inflation.

The unprecedented monetary and fiscal policy measures to boost economic activity taken in the US and Europe, combined with the conflict in Ukraine, led to the highest levels of inflation in over a decade. This sharp rise in inflation prompted more and more central banks to normalize their monetary policy more aggressively, which among other factors, has induced a severe correction in equity markets.

Since then, other central banks, including Canada, Australia and New Zealand have also decided to step up their fight against inflation, suggesting that there will be no pause in the normalisation of monetary policy until inflation shows signs of slowing, even if it is at the expense of economic growth. 

Inflation in Japan is bucking the trend

While inflation has risen sharply in many countries, inflation in Japan remains relatively contained. It is true that the base effect is favourable, as the country is struggling with historically stubbornly low inflation due to a series of factors, such as aging demographics, higher savings rates and a less consumption-oriented economy.

The chart below shows the consensus forecast of economists surveyed by Bloomberg for CPI inflation in the coming quarters. While inflation is expected to be over 7% at the end of the year in the US and the EU, in Japan inflation is expected to be around 2%.

 

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

After years of disinterest, Japanese equities have become attractive again

Japanese equities have been relatively discounted by investors over the last few decades due to their deflationary environment, but this factor could prove to be an asset in the current environment. Indeed, the relative weakness of inflation allows the Bank of Japan more flexibility in its monetary policy. Last Monday, Governor Haruhiko Kuroda reaffirmed his commitment to maintain ultra-loose policy by mentioning that the Japanese economy is still in a post-pandemic recovery phase and that rising commodity prices could weigh on the economic recovery. He added that in this context, "monetary tightening is not at all an appropriate measure”.

The chart below shows the performance of the major world indices since the beginning of the year and over the last three months. While all indices remain in negative territory since the beginning of the year, the MSCI Japan has recorded a positive performance over 3 months and the last 30 days, bucking the overall trend.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

On a relative basis, the ratio between Japan and World equities looks on the verge of breaking an important resistance

The chart below shows the ratio of the MSCI Japan to the MSCI World and how Japanese equities have long been ignored at the expense of US and European equities. The ratio has bottomed out above 50, a level also hit in 2012.

Since then, the relative momentum has been in favour of Japanese equities and a break of the upper bound of the uptrend channel could be a signal that a larger underlying trend is about to take hold.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

PTS Regional matrix: Japan ranks very bullish

Overall, our PTS regional matrix has turned very bearish as the trend grade (which is 40% of the total weight) has drastically declined after a series of negative moving averages crosses. However, Japan still has a very bullish regional score in our matrix (+33%) – on the back of strong valuation/trend scores (+33%) and perfect liquidity/economics scores (+100%).

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

The Japanese equity index is more cyclical, but this did not penalize it

Since the beginning of the year, recession fears combined with monetary policy normalisation, rising inflation, the conflict in Ukraine and the renewed lockdowns in China have created a challenging backdrop for global equity markets.

In this environment marked by an economic slow down, investors have mostly favour defensive stocks. However, as shown in the charts below, Japan has the highest percentage of cyclical companies among the major equity indices, with over 54% vs. 42.8% and 36.4% for the US and Europe, respectively.

Despite their cyclical nature, Japanese equities are outperforming. Is this a signal of a change in sentiment?

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.
Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

Despite global growth concerns, Japanese cyclicals are performing well

The chart below illustrates the performance differential between cyclical and defensive sectors in Japan (gray), Europe (blue) and the US (red).

Year-to-date, cyclicals are underperforming their defensive counterparts in the U.S. and Europe by 6.3% and 7.9%, respectively, while in Japan, cyclicals have strongly outperformed by nearly 10%. This divergence remained steady over the past quarters and months, with outperformances of 6% and 0.3%, respectively.

Japanese cyclical companies are benefiting from a series of factors, including the decline in the yen and their exposure to the global economy. Indeed, although largely domiciled in Japan, a number of Japanese companies, particularly those in the consumer sector, such as Sony, Nintendo, Honda and Toyota, tend to have global revenue sources.

Thus, while revenues may increase due to inflation (by hedging currency risk), the wages they pay have not really increased, which means that even in an inflationary and labor cost-increasing environment, their margins are relatively stable. 

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

Japanese cyclicals look particularly attractive in the context of an economic rebound from China

Companies listed on the Nikkei 225 tend to have high levels of exposure to foreign economies (the index's foreign earnings exposure is over 50%) - China and the U.S. in particular.

As discussed below, we expect the Chinese economy to gain strength in the coming months as measures to stimulate economic growth have been announced and COVID infections are reducing.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

China is taking steps to revive the economy and glimmers of hope are slowly appearing despite a further partial lockdown of Shanghai. An improvement in the Chinese economic outlook would be another positive factor for Japanese cyclicals.

Shanghai's two-month lockdown, the shuttering of many malls and venues across Beijing and movement curbs imposed in many cities in recent months have battered the Chinese economy, disrupted supply chains and slowed international trade.

Recently, Chinese Premier Li Keqiang also highlighted this economic weakness and even said that the current economic downturn was worse in some ways than when the pandemic hit in 2020.

While in Europe and the US, the COVID fears have clearly abated and, from a market point of view, already seem to be an old history, China's ultra-restrictive policy has led to further lockdowns in the country, which has weighed on the economic recovery and resulted in a sharp decline in manufacturing activity.

Despite a favourable national trend in new infections and the lifting of many restrictions on its 25 million inhabitants, the Shanghai authorities have decided to implement a new lockdown in a  district of 2.7 million inhabitants. This suggests that the zero-virus policy may continue to offer a series of mixed opportunities for the economy. On the other hand, the prospects for an improved health situation in the medium term, combined with the adoption of several other economic stimulus measures, have improved the outlook for the Chinese economy, in our view.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

Monetary Policy Divergence should continue to weigh on the Yen

Traders are increasing their bets to take advantage of this divergence in monetary policy with an increasing number of central banks deciding to accelerate the normalisation of their monetary policy, leaving the BOJ increasingly alone in its dovish stance.

Thus, the yen continues to weaken against a growing number of currencies. From a technical point of view, the USDJPY is approaching the 2002 high of 135 and a breach of this level could lead to a move towards 145. 

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

A lower yen bodes well for Japanese exporters. Historically, the correlation between the Japanese equity market and the direction of the yen is strong.

As shown below, the year-on-year performance of the Nikkei 225 is closely correlated to the annual change in USD/JPY. Indeed, dollar appreciation against the yen has in the past been associated with positive returns for Japanese equities, which is perhaps unsurprising given the Nikkei 225’s composition (mainly composed of cyclicals and exporters).

As a result, we think we could see the Nikkei 225 edging higher in the weeks to come should the recent weakness of the yen against the greenback prove to be a tailwind again.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

Relative valuation remains attractive

Finally, another factor that may encourage investors to consider Japanese equities is valuation. Relatively speaking (to the MSCI World), the MSCI Japan is currently trading one standard deviation below its long-term average, at around 0.77x the NTM PE of the MSCI World, another sign that the market is currently attractively valued:

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022.

The Nikkei made a positive breakout. Heading towards prior high

After the bearish “double top” pattern  at around 31k, the correction phase pushed the Nikkei 225 index back to its pre-covid level at around 24k. Since then, the positive momentum has resumed and the index has formed a bullish high in the process. This positive price action has triggered a further rise which has taken the price above the upper band of the bearish channel. The target of this positive breakout is around 31k and is given by the height of the channel. In addition, the stochastic oscillator has recently crossed positively and still has room to run before approaching the overbought territory.

Source: FactSet; Pictet Trading Strategy; as of 9/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of any Pictet financial research unit.

Conclusion

The wide monetary differential between Japan and the rest of the world, the prospect of an improving Chinese economy and the low level of the yen should support the export-oriented Japanese market, which also appears to be attractively valued and technically well oriented: a neat combination that suggests there are still tactical opportunities to seize.

The table below shows the names of Japanese cyclical stocks ranked by global grade with upside potential, as measured by the distance to Bloomberg consensus target price and distance to 52-week high, greater than 10%. We also screened for stocks with an RSI below 70 to avoid overbought stocks.

Source: FactSet; Markit, Copyright © 2022 S&P Global Market Intelligence; Pictet Trading Strategy; as of 9/6/2022. *Criteria are explained in the endnotes. The target price presented in the chart is based upon chart analysis. This is not the product of an

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