- Japanese equities have lagged other markets so far this year as macro headwinds have impacted corporate earnings.
- In this regard, there has been a clear divergence between the manufacturing and non-manufacturing sectors, with the former hit particularly hard.
- With valuations at historical lows in certain areas, there are stock picking opportunities for discerning investors willing to take a longer-term view.
Japanese stocks have lagged their global peers so far this year, as uncertainty over US-China trade frictions and the impact on the global economy have clouded the outlook for corporate earnings. While the analyst revision index has already reached its typical bottom and earnings trends should stabilise in the coming quarters, share prices are likely to remain volatile amid a steady stream of geopolitical newsflow.
While not immune to external headwinds, the Japanese economy remains relatively stable and H1 growth rates came in ahead of market expectations. Confidence among Japanese manufacturers has clearly weakened, but sentiment in the non-manufacturing sector is holding up. Employment conditions remain tight and capital expenditure plans are supported by non-cyclical factors such as investment in labour saving technology. The Bank of Japan remains highly accommodative and extensive counter measures will be deployed to mitigate the effects of the October 2019 consumption tax hike.
Manufacturing sectors have been hit hard
Against this macro backdrop, there has been a clear bifurcation in corporate earnings between the manufacturing and non-manufacturing sectors. In most global cyclical industries, company results have been generally worse than analyst estimates - with earnings declining sharply - while on the other hand some non-manufacturing stocks and sectors have posted solid earnings growth. One such example held in the Trust is JustSystems, an under-researched tablet-based learning and business software company that is generating double-digit profit growth as it takes share from paper-based education providers.
Looking ahead, it is possible that we see more manufacturing companies announce downward revisions to full-year guidance at the interim stage, especially if the yen appreciates further, although aggregate earnings should be up year-on-year in the second half of fiscal 2019 given the low hurdle rates.
Trade frictions coincided with a downturn in the technology cycle, and we saw, for example, semiconductor stocks falling by 50% relative from the peak in late 2017. As we come out of a negative inventory and supply cycle, earnings should bottom in the next quarter or two, and there are opportunities to buy companies at trough valuations. Notable examples held in the Trust include Tokyo Electron (semiconductor production equipment) and Renesas Electronics (auto-related semiconductors), both of which rank among the top 10 active stock weights.
Meanwhile, the machine tool cycle is in the final phase of the downtrend that started in the second half of 2018, and order levels should bottom out in the coming quarter. As we head into 2020, we should see a clear narrowing in the decline given the low hurdle rate versus a year ago.
The advent of 5G handsets will also create a new content cycle for globally competitive component makers even if the overall economic environment is not accelerating. For example, Fidelity’s proprietary research indicates that companies such as Murata Manufacturing, a global leader in capacitors and communication modules that is held in the Trust, are likely to see a c.50% increase in content per unit for 5G smartphones.
With valuations testing historical lows in some parts of the market, there are opportunities to capitalise on disconnects between near term sentiment and midterm fundamentals. I am focusing on companies that can grow consistently across cycles and those that are entering or are on the cusp of a new product cycle. I also continue to search for innovative companies at the pre-IPO stage.
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