Japan needs a weak yen? Maybe not…

Thanks to its large export orientation, Japan is likely to benefit in a strong dollar environment, notes Morgan Stanley.

Moreover, Pankaj Mantaney and team at Morgan Stanley in their June 15, 2015 research report on “Asia/GEMs Equity Strategy” point out that recent price correction is not enough to warrant an EM upgrade.

MSCI EM missed consensus earnings estimates

The Morgan Stanley analysts note that historically, since 1Q12, the MSCI EM Index has tended to correct after companies begin to report earnings. However, in the only two quarters that MSCI EM beat consensus earnings estimates (viz.: 1Q13 and 2Q14), the market trended upward after the earnings release:

MSCI Returns Japan

The analysts attribute the earnings miss in EM to the combined surprises of slowing domestic growth and a strong U.S. dollar. They anticipate this trend of earnings miss to continue.

Mantaney et al. point out that the recently concluded quarter was the 10th of the last 12 where MSCI EM missed consensus earnings estimates, while Japan beat consensus estimates for the 10th straight quarter:

MSCI EM-Missed 10 out of 12 quarters Japan

Thanks to their FX vulnerability and exposure to the falling commodities prices, earnings have been particularly weak for EMEA and LatAm regions. The MS analysts note MSCI EM actual 12-month trailing EPS has declined sharply to 69.3, being the lowest level since October 2010:

MSCI EM Index Japan

Moreover, the analysts note YTD, Brazil, Mexico, Thailand and Russia’s 12-month trailing EPS have dropped by over 10%. On the other hand, they point out that Taiwan is the only country where there has been a considerable upward trend in delivered EPS:

EM 12-month trailing EPS Japan

MS prefers Japan

Mantaney and colleagues maintain their stance of preferring Japan over MSCI APxJ (OW India and Taiwan) and over MSCI EM (UW Brazil, Russia and South Africa).  The analysts note MSCI EM Index is down 9% since its peak this year in April, while Topix is up 1.6% during the same period. They attribute three factors for the poor performance viz.: (a) another poor earnings season, (b) a sharp acceleration in the U.S. dollar, and (c) rising DM bond yields. Moreover, these factors are likely to persist for a while.

After a soft first quarter, US economic data has been rebounding in 2Q15. The MS analysts point out that strong U.S. data coupled with strong Eurozone inflation have provided fundamental support for ‘reflation’ and caused bond yield to shoot higher as well. They argue a dual hike of U.S. dollar and DM interest rates has tended to be associated with an underperformance of EM equities Vs DM:

EM performance Vs USD Japan

Of note, two other factors impact the MS top-down Japan EPS model viz.: Japan economy Watchers Expectations Index and Global PMI. The analysts point out that unlike in EM, the micro-level improvements in corporate governance and shareholder reward policies in Japan are having a positive impact on ROE.

Consensus EPS trend Japan

Finally, the MS report anticipates Topix will hit 10% ROE by end-2016, which is a 26-year high. They project Topix 12-month forward P/E on consensus estimate is 15.8x vs S&P 500 17.0x.