Prospects improve despite volatility

Japan’s exports, especially from America and Asia, took an upward turn and coupled with earnings upgrades, confounded conservative forecasts, which should entice investors again.

Despite disappointing earnings forecasts and ambiguous economic data, the Japanese market began the summer in positive mode. By June, many companies’ earnings estimates in May’s season had begun to look conservative, having been based on assumptions for a stronger yen, fears over weakened demand from America owing to subprime problems and a cautious view of sales and profit drivers.

A spate of earnings upgrades followed, reflecting not only a weaker-than-expected yen, but also continued robust demand from America and the strong fundamentals of many Japanese companies. These upgrades and rising expectations for a good first quarter earnings season offered support to Japanese stocks in June and July: First quarter profit growth was about 15% year-on-year, comfortably ahead of forecasts. Economic data in the early summer were also supportive for Japanese investors. The Bank of Japan’s quarterly Tankan survey, released in early July, suggested Japanese business confidence remained firm, while May’s machinery orders report, released in early July, came in ahead of consensus.

However, the Japanese market was hit by the global equity correction that began at the end of July. Rising risk aversion, prompting investors to sell equities globally, also triggered appreciation of the yen due to the unwinding of the carry trade. The stronger yen dented confidence in Japan’s recovery and had a detrimental impact on Japanese exporters.

Japanese equities continued to perform poorly in August, affected by fears of slower exports to the key American market, some mixed local economic data, and the same quant fund de-risking that affected all global equity markets. Local institutions are not buyers of equities, so this had a marked impact.

Some relief came in the middle of August, however, as America’s Federal Reserve buoyed global markets by cutting its discount interest rate. The Bank of Japan left its benchmark interest rate unchanged at 0.5%, pleasing investors, who had expected a rise. Governor Toshihiko Fukui emphasised that repricing of risk may take some time to play out, but maintained a positive long-term economic outlook.

Although volatility looks set to continue as global markets continue to absorb the aftershocks of the American subprime mortgage crisis, we remain broadly positive on our outlook for the Japanese market. Given the disappointing performance of the past six weeks, coupled with strong prospects for earnings upgrades over the coming months, Japanese stocks look particularly attractively valued.

The economy, meanwhile, remains on a steady growth trend. Despite recent events in America Japanese GDP growth for 2007 should at least align with the Bank of Japan’s forecast of about 2.1%. Such a level should be supportive for corporate earnings and, by extension, for the Japanese stockmarket.

Housing market data is also encouraging. Land prices rose in 2006 for the first time in 16 years as economic expansion boosted overseas and domestic property investment. Apartment prices continue to rise in Tokyo, and office rents are increasing, with vacancies at a 15-year low of less than 3%.

Following its recent falls, the Japanese market is offering some attractive value opportunities, with many quality mid-cap companies on historically low price/earnings ratios, while enjoying high double-digit earnings growth.

Earnings expectations for the year continue to look conservative and we expect companies to revise up their full-year estimates during the second half of the year. Earnings revisions ratios, which were the worst globally last year, should be stronger this year, encouraging investors back to the market. This can be seen already in the marked improvement in the Merrill Lynch survey of three-month profits momentum.

A further potential catalyst for the Japanese market would be an increase in consumer spending. As yet, there is no sign that tightening in the labour market is translating into higher pay, but with unemployment at a nine-year low the outlook for wages – and therefore consumer confidence – should be supportive.

However, until there is a pick-up in domestic consumption, the Japanese economy remains heavily reliant on exports. While exporters have suffered from fears the subprime crisis would lead to slowing demand from America, there has been little sign of this so far. July exports were solid with better sales to America and Asia, suggesting external demand is picking up. Car sales are still strong. In August, Toyota supplanted Ford to become the second-largest seller of cars in America.

Japanese exporters have diversified their markets and are less reliant on America. Demand from the Middle East, emerging markets and from other Asian markets has continued to grow as these regions spend heavily on infrastructure, raising their importance to Japanese companies. China – now Japan’s second most important export market – shows no sign of easing its massive demand.

The yen, meanwhile, is likely to stay the same or weaken. Although we have seen some unwinding of the carry trade, this has frequently been followed by yen selling as investor sentiment recovers, and we anticipate further large outflows in the coming months – positive for exporters, with the yen looking particularly competitive against the euro.

Overall, good corporate fundamentals remain in place. The economic outlook is positive, given the repercussions of the American subprime crisis do not impact global growth. We see the equity correction as being driven by the credit crisis, not by fundamentals; so we do not feel the need to make adjustments to our portfolio positioning. Rather, it has provided a buying opportunity in some of our high conviction names. The key themes of Asian growth – Chinese and Indian demand for materials and better news in the technology sector – have not been affected by the credit market hiatus.