Whither Japanese equities?

The Japanese equity markets are either home to some undervalued bargains or some disasters waiting to happen, depending on who you ask, but the latest Bank of America Merrill Lynch fund manager survey labels Japan the most unloved of all major markets.

The Japanese equity markets are either home to some undervalued bargains or some disasters waiting to happen, depending on who you ask; or possibly both. According to the October Bank of America Merrill Lynch (BAML) fund manager survey, Japan is officially the most unloved of the major markets, while others point to valuations that have yet to catch up with earnings recoveries since the financial crisis.

A combination of economic slowing in key global export markets, a strong yen, and domestic deflation territorial disputes with China – its biggest trading partner – have hit Japanese company balance sheets and stock prices. According to the BAML survey, 38% of global asset allocators are underweight Japanese equities, up from 23% a month earlier and the highest number in a decade.

The woes of sectors such as Japan’s once world-beating electronics manufacturers are well-documented, as firms such as Panasonic and Sony have posted huge losses, while Sharp questioned its own ability to survive at its earnings announcement earlier this month. Yet looking across the market as a whole valuations look cheap, with around 70% of companies in the TOPIX trading below book value. There are hundreds of financially sound companies trading at less than half their book value. P/E ratios are also trending near historic lows.

Nevertheless, after numerous false dawns of recovery on the Nikkei, true believers are becoming harder to find at home or abroad.

Japan’s big three banks – Mitsubishi UFJ Financial (MUFJ), Sumitomo Mitsui Financial (SMFG) and Mizuho Financial, posted combined losses on their equities holdings of ¥534 billion (US$6.7 billion) in the first half of the current financial year, three times worse than their performance last year.

The megabanks have been gradually unwinding their huge crossholdings over the years but they still have large stakes in struggling companies such as Panasonic and Sharp. But crossholdings of shares is more than a simple investment decision in Japan. It represents a sign of mutual support and loyalty between companies which often have other business ties. Nevertheless, the recent losses look set to accelerate their disposal programmes, though unloading them too quickly would further depress stock prices.

The predicament of some of Japan’s big corporations has now attracted the attention of global hedge funds, which have started betting on their troubles continuing and worsening. Panasonic, Sharp and Sony have all been targeted, with funds buying credit-default swaps (CDS), hoping the cost of insuring their debt rises as their financial struggles.

The cost of CDSs has been rising this year, but it dropped again more recently as the yen weakened amidst promises by Japan’s political opposition to expand monetary easing policies after its likely victory in the December general election.

The outlook for the world’s third-largest stock market is nothing if not uncertain, with both bargain hunters and bears likely to be active for the foreseeable future.