4 Reasons Japan Could Continue to be the Land of the Rising Stock Market

While U.S. stocks are having a stellar year, Japanese stocks are doing even better. Year-to-date,the Nikkei 225is up nearly 40%. Even after adjusting for a falling yen, Japanese stocks are up around 23%.

I continue to believe that Japan offers more upside potential in the next three months to six months, and I see near-term opportunities in the market, particularly if investors canhedge out the foreign currency exposure. The case for Japan relies on four arguments:

  1. Growth. For investors who still view Japan as the perpetual laggard, it’s worth pointing out that in the first half of 2013 the Japanese economy grew by around 4%, twice the growth rate of the U.S. economy. Expectations for the back half of 2013 suggest an economy likely to slow toaround 3% growth, still beating other developed markets. In addition, after years of entrenched deflation, Japanese prices are finally starting to rise, which is helping nominal growth as well as corporate profits.
  2. Expansive Monetary Policy. A large part of the reason for Japan’s turnaround is the Bank of Japan (BOJ). The new governor of the BOJ embarked onan aggressive asset purchase program of 7 trillion yen a month. Adjusted for the size of the Japanese economy, this is much more aggressive than the Federal Reserve (Fed)’s current quantitative easing (QE) program. Just as important, while the Fed is likely to start to transition out of its asset purchase program in 2014, the BOJ will likely continue to provide ultra-loose monetary conditions for at least another couple of years.
  3. Valuation. On botha price-to-book measureas well as a cyclically adjustedprice-to-earnings ratiocomparison, Japan continues to look cheap compared to the United States. Currently, the Nikkei trades at 1.5x book value, a 40% discount to U.S. stocks. While there are good reasons why Japan should trade at a discount, the size of the current differential suggests Japan is the better bargain.
  4. Share Buybacks. Japanese companies are profitable, just under levered compared to the U.S. ones. While leverage levels are likely to remain low, Japanese companies can deliver to stockholders in an alternate way: share buybacks, a trend that is already in place and that should raisereturn-on-equityand deliver cash to shareholders.

What are the caveats?

  1. To the extent that Japanese stocks continue to appreciate due to a declining currency – a cheaper currency is supportive of Japan’s export driven companies – investors will want to neutralize the currency exposure.
  2. While I like the prospects for Japanese equities over the next three to six months, the longer-term outlook remains unclear. As such, as I write inmy latest Investment Directions monthly market outlook commentary, I continue to advocate a benchmark weight to the market for most investors

For Japan to represent more than just a near-term trade, investors will want to see further evidence that the government is serious about implementingthe so called “3rdarrow” of structural reforms. If Japan is going to escape its multi-decade stagnation, rather than just enjoy a cyclical bounce, it willneed to address both lagging productivity and a shrinking workforce. The former will require reforms to its labor market and many cossetted industries, while the latter can be addressed by pulling more women into the labor market. In the absence of these reforms, Japan arguably still makes an interesting tactical trade, but not a compelling long-term investment.

Sources: Bloomberg, BlackRock Investment Directions

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Securities focusing on a single country may be subject to higher volatility. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest in an index. Past performance does not guarantee future results.

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