A temporary thaw in US-China trade tensions saw Japanese stocks rally last month and outperform both the US and broader global equities indices. But BlackRock chief investment strategist Mike Pyle said the world’s largest asset manager will not be changing its underweight stance yet.
September’s rally has seen Japan emerge as the best performer of the major equity markets since the middle of the year.
Pyle said the main driver of this performance was a “perceived easing of US-China trade tensions” although last month’s rally was likely an “exaggerated response”.
Total return of Japan, US and world ex-Japan equities, July-October 2019
Source: BlackRock
“Japanese equities have outperformed, contrary to our expectations, thanks to a lull in trade tensions that we see as temporary,” he said.
“We do not see this rotation having staying power though. In the near term we see potential for further bouts of market volatility, as fallout from the trade war is reflected in weak economic data.”
Trade disputes and geopolitical friction have become key drivers of the global economy and markets more recently, particularly as US policy under president Donald Trump has become increasingly predictable.
“In the near term we see potential for further bouts of market volatility, as fallout from the trade war is reflected in weak economic data,” said the BlackRock strategist.
Pyle said trade dynamics “play an outsized role in Japanese equities” with as much as half of the revenues of Nikkei 225 companies come from exports despite the fact that exports’ contribution to Japan’s GDP is just 15 per cent.
“China is the largest market for Japan’s exported goods, and orders from China for machines and electronics parts have collapsed since November 2018,” he said.
“We see a lull in China’s growth due to the fallout of US tariffs. China’s policy stance is likely to ease further to help stabilise growth, yet an incremental boost to growth seems unlikely, in our view. Japan’s leverage to global trade leaves it vulnerable to any further downdrafts tied to the protectionist push.”
In addition, Japan faces a number of domestic challenges including the impact of a recent sales tax increase and a lack of policy space for the Bank of Japan after years of ultra-loose monetary policy.
As such, the asset manager remains underweight Japanese equities for now, said Pyle.
“We still expect weakness in global growth data over the next few months, as easier monetary conditions slowly filter through to benefit the broader economy in the next six to 12 months,” he said.
After the UK, Japan is the sector fewest international asset allocators believe will outperform in the 2020s, according to the most recent Bank of America Merrill Lynch Global Fund Manager Survey.
Which equity market will outperform the most in the 2020s?
Source: Bank of America Merrill Lynch Global Fund Manager Survey
The survey also found that Japanese equity allocations fell to around a 4 per cent underweight in October down from a 1 per cent overweight in September, “seeming reflecting a cautious stance against cyclical assets”, the bank found.
With a US-China trade war the biggest tail risk among international asset allocators, any potential agreement could help reallocation towards Japan in the near term.
As such, BlackRock’s Pyle said its stance towards Japanese equities could change should a prolonged truce break out between the US and China.
“Their close correlation with the health of global manufacturing activities and China’s growth, as well as their beaten-down valuations, could make them attractive,” the strategist explained.
Indeed, the Bank of America Merrill Lynch Global Fund Manager Survey found that a net 26 per cent of respondents believe that Japanese equities are the most undervalued region.
And the recent rally in equities could hold a preview for potential market reaction should the global economy reaccelerate in 2020.
“Japanese equities’ cheapness could exaggerate any such move,” said Pyle. “The price-to-earnings ratio of the blue-chip Nikkei 225 Index has fallen to an historical low of 12."
The BlackRock strategist added: “Another positive in the background – Japanese firms are gradually improving their corporate governance, reflected in increased payouts to investors in the form of dividends and share buybacks.”