Manulife Asset Management: Expecting strong support for the Japanese stock market, pay attention to high-quality companies with strong pricing power

According to the Zhitong Finance and Economics APP, Edward Ritchie, head of the Japanese stock department at Manulife Investment Management, stated that considering the dividend yield and the company's commitment to repurchasing shares in the coming years, it is expected that the Japanese stock market will receive good support. It is estimated that the overall shareholder return rate of the Japanese stock market in 2024/25 will exceed 5%. Investors should continue to pay attention to high-quality companies with strong pricing power and effective capital allocation.

The Japanese stock market accumulated a decline of over 20% in the first three trading days of August, with a single-day drop of up to 12% on August 5th. Edward Ritchie pointed out that the main reason for the sharp market decline is that global investors suddenly changed their expectations, fearing a global economic recession led by the United States. This view stems from the belief of some investors that the lack of a rate cut by the Federal Reserve at the end of July was a policy mistake, and the weakening data on U.S. employment and industrial demand just confirmed their views. This shift has led to a large number of investors avoiding risks.

One of the largest risk trades globally is the so-called yen carry trade, which involves global investors shorting the yen and investing in the Japanese stock market. Investors seeking to reduce risks or unwind yen carry trades have been a major factor in the sharp appreciation of the yen and the decline in the Japanese stock market.

Several other factors have contributed to this shift in investment sentiment and exacerbated the market downturn. On July 31st, the Bank of Japan raised its policy rate from 0% to 0.1% to 0.25%, leading to a stronger yen. The expected appreciation of the yen will weaken the profit prospects of Japanese exporters, but the impact of the yen on overall corporate profits in Japan is not as significant as it used to be.

In fact, many Japanese manufacturers are currently producing overseas, so the currency impact tends to be more about conversion (converting overseas profits into yen) rather than transactional nature (selling products produced in Japan to overseas markets based on yen costs). Some commentators also believe that a rate hike in Japan may lead to a slowdown in the local economy, but this is not the main risk.

Another reason for the market decline is the changing sentiment towards global tech stocks starting in early July. A leading tech company announced weak earnings on August 1st, with quarterly profits plummeting by 85%, followed by an announcement of a 15% workforce reduction, deepening market concerns about the growth prospects of tech stocks. Geopolitics remains a continued risk for investors, as tensions in the Middle East seem to be heating up again, but this was not the main reason for the sharp change in market sentiment in early August.

Edward Ritchie stated that there was a general sell-off in the market, with all industries recording declines of over 10%. The financial sector (banks, insurance, and securities firms) performed the weakest, followed by trading companies and the automotive industry. The best-performing industries were mainly domestic and defensive industries, such as retail and healthcare, as well as railways and telecommunications.

As the market's view on further rate hikes has changed, coupled with a decline in the 10-year bond yield (the 10-year Japanese government bond yield has dropped from over 1% to below 0.8%), the financial sector has been hit the hardest even if businesses are not exposed to yen currency risks. Additionally, as of the end of July, market pricing reflects that the probability of a 25 basis point rate hike by the Bank of Japan by the end of 2024 has dropped to close to 0%. These developments have all changed the investment sentiment in the financial stock market Japanese domestic industries and generally defensive industries have performed better, reflecting a stable local economic outlook in Japan. Japanese consumers have been facing the dilemma of rising prices, and substantial wage growth has only recently turned positive. The strengthening of the yen has led to a decrease in import prices, bringing positive effects to local Japanese companies and should help support the local economy. In terms of factors, growth stocks and momentum stocks have been hit the hardest, while stocks of companies with high quality ratings and high free cash flow yields have experienced smaller price declines.

It is difficult to determine how long the unwinding of the yen carry trade will last and what impact it will have on the Japanese stock market. However, drawing from past experiences of significant market sell-offs, such as the sell-offs following the Fukushima nuclear disaster in March 2011 or triggered by the COVID-19 pandemic in March 2020, markets tend to rebound after a brief sharp decline (both sell-offs recorded a drop of 16% to 18% in less than a week).

Currently, the price-to-earnings ratio of the Japanese market is 12 times, which is considered reasonably valued, and companies have made conservative profit forecasts. Based on an average exchange rate of 140 yen to the US dollar, earnings for the fiscal year 2024/25 are expected to remain stable. In comparison, the price-to-earnings ratio of the US market is 22 times, indicating significantly higher valuation.

Considering dividend yields and companies' commitments to share buybacks in the coming years, the Japanese stock market is expected to receive good support. It is estimated that the overall shareholder return rate of the Japanese stock market in 2024/25 will exceed 5%. Investors are advised to continue to focus on high-quality companies with strong pricing power and effective capital allocation. If market declines present attractive investment opportunities with potential high returns, or if prices fall to what investors consider reasonable, investors should seek opportunities to increase holdings in some high-conviction positions.

Manulife Investment Management maintains its view on Japan: Japan is currently transitioning from deflation to inflation, and companies with pricing power will be able to sustainably raise prices. In this environment, the profitability and free cash flow of Japanese companies will grow more steadily, helping to drive continuous revaluation of the Japanese stock market.

Manulife Investment Management points out that before the market decline, the Bank of Japan is expected to raise interest rates once or twice in 2024, and further raise rates in 2025 to promote rate normalization. The Bank of Japan has not defined the level of normalizing interest rates, but it is expected to be higher than the current 0.25% level. The market no longer anticipates further rate hikes in 2024. After all, further rate hikes by the Bank of Japan will depend on whether the inflation rate remains elevated (Japan's consumer price index is currently at 2.8%). The recent strengthening of the yen has led to a decline in import prices, which may help curb rising inflation.

The unwinding of the yen carry trade frenzy means that investors are no longer affected by significant fluctuations in the yen. This will give the Bank of Japan greater freedom of action in the future (to take further rate hike actions) without worrying about causing chain reactions in the financial markets