Japan: a diversifier for equity portfolios

Japanese stock indexes proved an exception to the negative returns registered by developed-market equities in September, and even reached all-time highs on a total return basis in the middle of the month. The catalyst for Japanese outperformance was the resignation of prime minster Yoshihide Suga. 

The new prime minister appointed at the beginning of October, Fumio Kishida, is not expected to be a be a policy innovator himself but he will provide stability. In addition, the state of emergency imposed following a covid-19 outbreak during the summer Olympics was fully lifted on 1 October. This should pave the way for recovery of the domestic economy that so far has proved sluggish. A stimulus package being discussed by the new prime minister’s cabinet before the holding of a snap general election could boost the Japanese recovery and so, potentially, could enable returns on equity for Japanese stocks catch up further. A major factor in the underwhelming performance of Japanese stocks before September was the Bank of Japan, which halted its purchases of equity ETF buying in Q2. But the central bank may provide further direct help to equities if market jitters increase.

There are other reasons to consider Japanese equities. Even though Japanese earnings have outperformed European earnings over the past couple of years, Japanese equities still show a slight valuation discount. And at a time when the classic diversification benefits of bonds are being challenged, it makes sense for equity investors to look for diversification within equities themselves. Japanese equities could be just such a diversifier, thanks in part to the yen, which historically has tended to appreciate during global equity sell-offs. Since 2007, the yen has risen an average 1.8% against the USD during S&P 500 sell-offs (with some recent exceptions such as last month). The positive returns they notched up in September while equities elsewhere fell serve to emphasis the unique features of Japanese stocks.

We are leaving unchanged our year-end target of 2,050 for the TOPIX as we wait to assess potential policy initiatives following the change in prime minister and the calling of early elections. Overall, we feel the diversification benefits they offer justify our positive stance on Japanese equities at a time when fixed income is being challenged by on-going inflation pressures.