How to weather the Japanese storm

Another year, another Japanese prime minister. Thankfully, when we buy Japanese equities, we are buying Japanese companies, not the Japanese economy and certainly not the Japanese government.

We are extremely bullish about the prospects for Japanese equities. This optimism is founded on multi-decade valuation lows, very strong earnings growth despite the earlier knock to production from the earthquake and tsunami, rising dividend yields and continued evidence of M&A activity, as Japanese firms look to take advantage of ludicrously cheap corporate assets.

External woes

Earlier share price weakness over worries over the impact of the natural disasters on production and growth has given way in recent weeks to further tough market conditions, this time driven by events outside Japan.

Global macroeconomic concerns, namely the eurozone sovereign debt crisis and fears over America’s faltering economic recovery, have led to significant falls in equity markets across the world.

Japan is not immune from global macro problems; indeed the Japanese market, as measured by the Topix Total Return Index, is down 11% since the end of July in yen terms, albeit the already bombed out nature of the Japanese market means it has defended better than a number of other developed markets in the recent global sell-off.

Corporate rebound

If the global backdrop had been more benign, it is likely that by now the Japanese market would have been considerably higher.

The press was preoccupied with the Japanese government’s inept response to the earthquake, yet the speed with which corporate Japan resumed production was extremely impressive. First-quarter earnings were announced during August and it quickly became clear that most companies’ first-half forecasts were too pessimistic.

A number of companies have already revised up earnings estimates; this is quite unusual, as Japanese management usually prefers to wait until the first half of the year is over before making any changes to their forecasts.

Companies are also hiking dividends and buying back stock – all signs of increasing confidence.

The market, however, has chosen to ignore the positive news from the first quarter and instead has worried about the impact of the current global slowdown on second-half earnings.

To be fair, if the global economy is slowing as rapidly as it appears, this will certainly have an impact on Japan. But it is important to remember that the Japanese economy is currently out of synch with the rest of the world as it recovers from the earthquake and tsunami.

The recovery from the disasters means that Japan is probably in a better position to withstand a global slowdown than it has been for some time. The government has finally passed the legislation to allow earthquake reconstruction to begin and domestic consumers, having exercised self-restraint in the spring, are back in the shops. Even Japan’s exporters are less exposed to a downturn than might be supposed as inventories are still very low because of the earlier disruption to supply chains.