Japan Long/Short 2018 Outlook
Japan’s stockmarket rallied strongly in 2017, following the recovery of both the economy and corporate profits. Paul Kirkby reflects on the last 12 months and how he is positioning the portfolio for the year ahead.
In 2017, Japanese stocks were driven by a number of factors. We have seen the continued recovery of stocks from the oversold levels seen in the first half of 2016, as investors began to recognise that the Chinese economy was improving and that the long recovery of the world economy from the financial crisis lows, though slow, was continuing. This has resulted in a period of synchronised global growth, similar to the 2005-07 period (albeit at a slower pace). In Japan, in the third quarter, the economy notched up its seventh consecutive quarter of growth, the longest such run since 2001.
Did your strategy perform as you would have expected in 2017?
In broad terms, yes. Performance in absolute terms was strong in 2017.* One area that provided more opportunities than we expected at the beginning of the year was technology – particularly in stocks connected to car electrification (such as battery materials), 3D NAND (a variant of flash memory) and OLED screen (high-quality smartphone and tablet display) capacity build out. By historic standards (since 2002), the strategy's total net exposure started the year at elevated levels: approximately 60%. Although it edged lower during spring, it was subsequently dialled up during the summer and the second half of the year.†
What do you think will be the key drivers for your markets in 2018?
2018 could well see more of the same, but with more conflicting drivers possible in the second half of the year. The economy is likely to continue to improve, as will company profits. Corporate governance will remain a theme of interest which may begin to pull in foreign activist and private-equity investors. Examples in 2017 included a major multinational conglomerate agreeing to sell its 50% interest in a telecoms equipment manufacturer (one of the portfolio's holdings) to KKR, a US private-equity group, which subsequently tendered an offer for minority shareholders. This was followed by stake building by activist US hedge fund Elliot Management. We believe 2018 is likely to see more activist interest, with approximately half of listed companies in Japan having balance sheets which are net cash†† – which in an environment of improving corporate governance presents a compelling scenario for investors. This increased interest may attract more foreign portfolio buyers. It is noteworthy that foreigners, who were sellers in 2016, were only modest buyers in the last year, thus missing out on much of the rally.
In the latter part of 2018, changing perceptions of the outlook for the US and Chinese economies may begin to drive markets. US economic growth could very well continue to forge ahead, but the recovery is now one of the longest since the Second World War. Moreover, with China's Communist Party Congress having passed, Beijing is showing signs of becoming more willing to deal with the problems of high leverage, excess industrial capacity and environmental degradation – to the possible shorter-term detriment of the economy. In the meantime, the Japanese economy appears to be on a firm footing, such that investors later in the year may finally begin to discount the positive impacts of an emergence from deflation (which might push investors to financial stocks).
How are earnings revisions and valuations looking relative to historic averages and other markets?
Earnings revisions had been positive throughout much of last year. However, the market still trades at just under 15x 2018 calendar-year consensus price-to-earnings ratio and a 2018 price-to-book ratio of around 1.3x.# In other words, despite the profit growth seen in recent years, the market has not been re-rated – unlike, for example, the US S&P 500 and the MSCI World indices.
What are the biggest risks to your markets in 2018?
Domestically, ‘made-in-Japan’ risks seem modest in our view. Rather, the potential risks all appear to come from outside the country’s borders. Politics itself has rarely been a reliable ‘risk-on’ or ‘risk-off’ guide to market direction in Japan, but it is worth noting that, compared with what we see today in most G7 countries, Japan is an island of relative political calm, particularly with the general election out of the way. To put it simply, the opposition is either weak or shares many of the views held by the government – which reduces the likelihood of major political disruption.
Overseas risks include: a slowdown in China (as well as financial risks associated with its attempts to rein in the non-bank financial sector); a maturing of the long US recovery; political instability emanating from the US
(which has traditionally been associated with low political risk and therefore is a tricky one for markets to assess); and a peaking of the long bull market in the S&P 500, which could provoke a ‘risk-off’ move in global markets.
What is driving balance-sheet positioning at the moment?
The recovering economy and profit growth, combined with the ‘low hanging fruit’ found on company balance sheets, has led us maintain the constructive view on market prospects we have had since the autumn of 2016. Back then we reduced much of the portfolio’s short cyclical exposure and we subsequently trimmed this further in the second quarter of 2017 by cutting shipping shorts. This is a position we have broadly maintained since. Having become less concerned about top-down issues in the autumn of 2016, we have populated the long book with a number of bottom-up ideas, resulting in increased net exposure. Providing some of the risks referred to previously do not materialise, it is our current intention to maintain a constructive stance on net exposure into 2018. Where we remain optimistic about the prospects of the longs, we may, from time to time, seek to gain some protection of the large net long position, via the use of put options or put spreads on the stockmarket indices.
*Source. Martin Currie over 12 months to 31 December 2017. Strategy figures in US dollars from a representative account using official NAVS calculated by the administrator and net of all fees and expenses. This data is presented net of investment advisory fees, broker commissions, and all other expenses borne by investors. The figures provided includes the re-investment of dividends. The annual fee rate used is net fee rate of 1.50% (with a 20% fee rate).
†Source: Martin Currie as at 30 November 2017. Data calculated for the representative Martin Currie Japan Absolute Return Fund.
††Source: CSLA Securites Japan Co. Ltd.
#Source: Bloomberg as at 20 December 2017. Market referenced is Topix.
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