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Structural changes have helped the Japanese equity markets turn a corner. Now it’s time for investors to take notice.

In fact, Japanese equities are set to outperform their global counterparts, at least for the short term. Nikko Asset Management projects that the Nikkei 225 Index will outperform the S&P 500 from now until March 2020. The firm projects the index will hit 24,500 in March 2020, an increase of about 16% increase over current levels. Nikko projects a 5% increase for the S&P over the same time period.

The Nikkei over the past decade

According to Nikko Asset Management’s projections, the Nikkei 225 will hit 24,500 in March 2020. It returned -12.08% last year, but in each year since Abe’s government introduced a set of economic reforms that has come to be known as Abenomics, the Nikkei was in the black. In 2013, the index returned 56.72%; it returned 7.12% in 2014, 9.07% in 2015, 0.42% in 2016 and 19.10% in 2017.

Return on equity is nearing 10%. Between 1993 and 2012, ROE averaged around 4%. This is a dramatic step up, reflecting better governance and expectations from the GPIF of better returns

Chris Dyer
Director of global equity at Eaton Vance,

Xav Feng, director of Lipper Asia Pacific Research at Refinitiv, said that the past decade has been somewhat of a “lost decade” for investors in the equity markets. “Japan didn’t just end up with low inflation, low interest rates and low population growth, but rather, deflation, negative interest rates and negative population growth.”

However, with structural reforms, companies have increased share buybacks to their highest levels since 2006, benefiting shareholders greatly. Mr Dyer noted that many Japanese companies are underleveraged, making it cheap to buy back their stock. “Including buybacks, Morgan Stanley projects the total yield of the TOPIX in Japan to reach 3.7% in 2019—the highest level of the post-crisis period,” Mr Dyer said. “Return on equity is nearing 10%. Between 1993 and 2012, ROE averaged around 4%. This is a dramatic step up, reflecting better governance and expectations from the GPIF of better returns.”

Are international investors aware of what’s going on?

Mr Dyer said global investors are still underweight Japanese equities relative to the economy’s size. He said some investors might still not be convinced of the opportunities provided by Japanese equities. “The Japanese economy is very dependent on exports and global trade, and there is some concern trade tensions have steered investors away,” Mr Dyer said. “We think that this lack of interest so far could be a driver of multi-year outperformance.”

European investors have been pulling money from Japanese funds recently, according to figures from Lipper from Refinitiv. Japan-focused funds have witnessed outflows since December. In the US, Japan-focused funds have seen outflows each year since 2016. That year, Japan funds saw their highest outflows, with investors pulling $9.72 billion.

Tom Roseen, head of research services at Lipper from Refinitiv, said recent outflows come down to the trade conflicts. “Because of the trade problem, is a softening global market going to impact them?” he asked. “The answer is yes. For the first five months there are $2 billion in outflows more than that point in 2018. Anyone doing exporting right now is concerned with what’s going on with China and Mexico. The US is a bit of a loose cannon now with tariffs. If Chinese growth slows, it trickles through to everybody.”

Opportunities presented by the Nikkei

The Nikkei 225 Index provides investors with exposure to the biggest and brightest Japanese companies. Mr Roseen noted that many names in the index are low-growth companies, but they are established global conglomerates that pay handsome dividends—attractive qualities to investors looking for an income play.

Mr Feng said many investors are turning to exchange-traded funds that track the Nikkei 225 as a means to invest in the Japanese market. “For investors who are not familiar with but interested in Japanese market, buying a Japan ETF is the easiest and direct way to participating Japan market’s growth,” Mr Feng said.

Japanese equities are well positioned to grow, thanks to low valuations and hopes for trade deal between China and the U.S. Other growth drivers include structural improvements, such as the market and governance reforms put into place by the government of Prime Minister Shinzo Abe, and increased domestic equity investment from Japan’s pension fund—the Government Pension Investment Fund (GPIF).

“We needed to see higher payout rates, better management and governance from Japan and that’s what we’re seeing,” said Chris Dyer, director of global equity at Eaton Vance. “They’re buying back shares, they’re appointing independent directors, and this is all boosting returns on equity. We think that there is a lot of scope for improving returns going forward. This market is more focused on self-help than others.”

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