Investors in Japan funds will see another year of strong outperformance, according to Alan Mudie, head of investment strategy at SG Hambros, who adds emerging market funds are not looking attractive despite their sharp falls over the past 12 months.
Presuming you were either very wise, very lucky or had a crystal ball, the ideal portfolio to hold last year was substantially overweight Japanese equities with little or nothing in funds with high weightings to emerging market stocks.
FE data shows that in 2015, the average fund in the IA Japan and IA Japanese Smaller Companies sector returned a hefty 15.66 per cent and 16.43 per cent, respectively. In contrast, the average fund in the IA Global Emerging Markets sector 10.19 per cent.
Performance of sectors in 2015
Source: FE Analytics
For Mudie this trend looks set to continue throughout 2016 with Japan funds being his favourite overweight for portfolios. On the other hand, he says a dire start to the year for the Chinese markets forewarns another dire year for the developing world.
In regards to Japan, Mudie says macro fundamentals are looking good due to increasing job creation levels and capital spending while, at the same time, there is a possible expansion of the Bank of Japan’s quantitative easing [QE] programme around the corner.
“It is absolutely our favourite overweight. Last year it was too. Part of the reason is growth. Forward earnings growth for the Japanese equity market is the highest of those of any we measure. They are higher than the eurozone, US and UK,” he said.
“Also, valuations. On the forward price earnings model, Japan is trading at 13.8x forward earnings and that is around a 20 per cent discount to the average forward price earnings ratio for the Japanese equity market over the last decade,” he added.
“So it is cheap relative to its own history, it is cheap relative to global equity markets, has higher growth and has improved corporate governance.”
He says despite the overall strong run overall last year for Japan, investors sold out over the summer and haven't got back in as of yet.
“It is under owned and undervalued, which is a very powerful combination.”
Japan’s strong run in 2015 carried on a trend from the two previous years when sentiment started to rise shortly after prime minister Shinzo Abe’s re-election to office.
Over the past three years, the Japanese economy , and partly in tandem, the sentiment to its stock market, has gradually improved under Abe and his brand of economic and structural reforms labelled ‘Abenomics’.
While Abe’s signature policies to revive the economy, which consist of three “arrows” (stimulative monetary policy, a reconstruction of Japan’s fiscal accounts and a set of structural reforms) have made progress, it was the announcement of a QE expansion at the end of 2014 that saw the market fly, as Invesco Perpetual’s chief economist John Greenwood notes.
Funds such as Legg Mason IF Japan Equity, Lindsell Train Japanese Equity and JPM Japan and have delivered stellar returns of 143.43 and 92.77 per cent over three years, and doing particularly well following the announcement a year or so ago.
Performance of funds, sector and index over 3yrs
Source: FE Analytics
However, many investors were clearly taking profits following the rally and the market is still down from its April 2014 high.
On the flip side Mudie says they are few reasons to be cheerful about emerging markets which have suffered strongly from the China led sell off last year and more broadly from ongoing weakness in commodities.
In the first day of trading in 2016 Chinese equities, the largest constituent of emerging markets, fell substantially as a result of poor PMI figures which resulted in the closure of stock markets.
Today, less than one in ten of the funds in the IA Global Emerging markets sector are in positive territory over three years. Just six out of 73 of the peer grouphave bucked the trend over this period with the best performing exceptions including the Templeton Emerging Markets Smaller Companies, Hermes Global Emerging Markets and Carmignac Portfolio Emerging Discovery funds.
Performance of funds, sector and index over 3yrs
Source: FE Analytics
“We are still very underweight emerging markets equities. The volatility of the Chinese market is so far keeping us on the side-lines.”
However, he says there is more value in Indian equities and the team at SG Hambros are reasonably constructive on the country’s stock markets.
“We are also very firmly of the view that the reform programme by Modi will bear fruit and we like in particular the focus on the focus of encouraging innovation and entrepreneurship in the Indian economy.”
“The Indian equity market actually looks quite attractive on a simple price to earnings ratio it does look expensive trading at 16x forward earnings, but that is actually a discount compared to the last 10 years.”