Tuesday, March 31st, 2015

The Abe Put

Regular readers will know that we have been bullish on Japan for some time. Our most recent note was Gogi Ichiba (February 17th, 2015) where we highlighted nine reasons why we thought that the market could break through its previous multi-year high around 18,000 on the Nikkei. These included monetary policy, political stability, accelerating credit growth, rising return on equity, better corporate governance and relative valuation. Since we have been slightly surprised by the speed with which an overweight recommendation has become consensus. We still think this is the right call, but it is time to revisit it in the light of changing market conditions.

That note focussed on reasons why Japan could outperform a rising world index. Since then we have become more cautious on the outlook for global equities, thanks to the anaemic performance of the US, which has lagged behind all developed markets in the year to date, once the dollar effect is excluded, and is only just ahead of emerging markets. This week we have downgraded the US to underweight relative to other equity regions. This naturally prompts the question whether the poor performance of the US will eventually drag down the rest of the global index. Our answer is yes – if it carries on for long enough. We continue to believe that the translation impact of the strong dollar has been underestimated and that there would be further downgrades to US earnings for 2015, even if there was no further appreciation. At some stage – in Q2 or maybe in Q3 – we expect the strength of the dollar to trigger the first significant correction in US equities in over three years. When that happens we would also expect there to be a sell-off in the dollar, and significant gains for the euro and the yen.

The consensus argues that Eurozone and Japanese equity markets would react equally badly to this scenario. We disagree for two reasons. First, international investors have been slow to grasp the scale and power of the reforms in corporate governance, which we believe is on a par with the Thatcher revolution in the UK in the 1980’s. One example is the development of the Nikkei 400, which weights Japanese companies according to their return on equity (among other things) as well as their market capitalisation and which is being officially supported as a new benchmark for domestic pension funds. The aim is to boost the average return on equity for Japanese companies from a pitiful 6.5% to something nearer the 14.5% achieved by the S&P500. This is obviously a long-term target, but there is no equivalent of this approach in the Eurozone.

Our second reason is decidedly short-term. As part of the reform package it was announced that the Government Pension Investment Fund, which has a total portfolio of US$1.15 trillion, would increase its weighting in domestic equities to 25% plus or minus 9%. As of the end of February this figure now stands at 19.8%. In order to meet its target weight the fund still has to buy another US$60 billion of domestic equities. If the managers felt that a market correction offered a compelling opportunity, this figure could be increased by another US$100 billion without breaking the upper limit of the target range. This is the Abe put. It is (a) large and (b) unique and (c) ready for action.

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