We still expect Japanese equities to gain ground over the medium term as company earnings improve, but based on FY13 forward P/E ratios we do not think Japanese equities are as undervalued as they have been, relative to the other major stock markets in developed economies. Tokyo’s stock market could continue to adjust in the short term, until there is greater investor confidence in a major improvement in company earnings.
Japanese Equities: TOPIX ended the week 4.7% lower
A sharp drop on Tokyo’s stock market on May 23 meant TOPIX ended the week down by 4.7%. TSE2 lost 2.3% this week and JASDAQ fell 6.4%. Stocks had previously made strong gains over a short period and were looking overheated, but corrected on weak economic news out of China.
Japanese Equities: Combination of overheating and high valuations
Prior to this week’s sharp decline, there were growing signs of overheating in Tokyo from a technical standpoint, as stocks had made an almost unbroken ascent, and at a rapid rate, since mid-November. TSE1 was looking overvalued, at 17.8x FY13 EPS estimates as at May 22. There were also signs that a limited number of stocks were pushing up the overall market, as the number of stocks falling in value looked high relative to the stock market index’s rise. On May 23, the stock market eventually gave in to the combination of signs of overheating and high valuations.
Japanese Equities: Direct catalyst was a drop in China’s PMI
We think a direct catalyst of the market’s sharp decline was the news that HSBC’s China manufacturing PMI had unexpectedly dropped below 50, to 49.6. Prior to this news release, Japanese stocks had been gaining in morning trading in reaction to the yen’s weakness. We think the reaction in Japan to the PMI release, which was met with a much milder reaction in China, is an indication of how overheated Japanese stocks had become. Moreover, the rally to date had pushed long arbitrage positions between stocks and futures to more than ¥4.3trn (around 1% of TSE1 market cap). We think the market’s decline was given added momentum by investors unwinding these positions.
Japanese Equities: Economics minister appears to issue warnings about the weak yen
There had also been some disappointing signs regarding the weak yen and the loose monetary conditions that have been driving the equities rally. On the forex side, Japan’s economy minister Akira Amari appeared to send warning signals this week about the yen’s weakness. On May 19, Mr. Amari said further yen weakness could have a negative impact on people’s lives, and on the 21st he said he hoped the forex market could strike a balance between its impact on imports and exports. The real intention of his remarks is unclear, but we think they led the markets to believe the government has started to worry about the yen’s depreciation. The yen strengthened on news of the stock market’s correction, touching ¥100.83/$ as investors sought out the currency as a safe haven. We think any warnings about the yen’s weakness will work against Japanese equities, given that the stock market has priced in a boost to company earnings from the yen’s decline.
Speculation that the Fed will scale back QE3 soon
In terms of monetary conditions, speculation has emerged that the Fed could scale back its quantitative easing program relatively soon. This view was sparked by a statement on May 16 last week from the president of the Federal Reserve Bank of San Francisco, who is considered a supporter of monetary easing. The president said the Fed could start reducing the rate of asset purchases as early as summer. During his congressional testimony on May 22, Fed Chairman Ben Bernanke emphasized the risk of tightening monetary policy too soon, but hinted at the possibility of the Fed reducing asset purchases over the next several monetary policy meetings. We think this left market observers on edge about whether the Fed will taper QE3 soon. In Japan, while the long-term JGB market remained volatile, the BoJ did not announce any concrete steps to bring long-term interest rates down, following its May 21-22 monetary policy meeting. This led to speculation that the BoJ will tolerate an increase in long-term yields, and on May 23 Japan’s long-term interest rate touched 1%. A sharp rise in long-term rates tends to have negative implications for the stock market, as it is bad news for the underlying
economy and reduces the risk tolerance of financial institutions.
Japanese Equities: 7.3% Nikkei drop is the 10th largest ever
The above developments came to a head on May 23, when a combination of signs of stocks overheating, news of China’s weaker economy, weak yen warnings, and concerns about a scaling back of liquidity sent the Nikkei 225 Stock Average down 7.3%, its 10th largest drop ever in percentage terms, and TOPIX down 6.9%, its 13th largest drop. On the same day, TSE1 posted record trading volume of 7,655.14mn shares and trading value of ¥5,837.6bn. On May 24, the Nikkei recouped 128 points, but only after a volatile session in which the index was up 523 points at one stage in morning trading and down 502 points at one stage in the afternoon.
An example of a similarly sharp stock market decline in recent years is the “flash crash” by the New York Dow Jones Industrial Average on May 6, 2010. At one point, the Dow was down 998.5 points (9.2%) on the previous day. The index regained some strength by May 12, but entered another downward trend amid a lull in economic sentiment and finally hit bottom on July 2. We think Tokyo’s stock market deserves close attention going forward, given the number of weak economic indicators in the US and China.
Japanese Equities: Gains and losses by sector
This week, 30 of the 33 TSE sectors retreated. The strongest sector was air transportation, followed by iron and steel, and marine transportation. The weakest sector was real estate, followed by other financing business, and banks. In other words, sectors that have benefited from monetary easing were hit hardest.