Interactive Investor

Record highs in US and Japan, but should investors stick or twist?

Is it time for investors in these two markets to take some profits, hold, or keep buying, asks David Craik.

22nd April 2024 09:27

by David Craik from interactive investor

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US and Japan flags waving in the breeze 600

While many investors have spent time over the past few months fretting about global economic and geopolitical uncertainty, US and Japanese stock markets have been powering happily forward.

The S&P 500 and Dow Jones Industrial Average indices have hit record highs this year, with Japan’s Nikkei 225 index soaring to its highest level in 34 years in February of 38,915.8, despite sluggish economic growth. Since then, the Nikkei 225 has even breached the 40,000 mark.

Why US and Japan markets hit new peaks

US markets have been largely propelled by the so-called Magnificent Seven group of tech stocks such as Inc (NASDAQ:AMZN) and the artificial intelligence (AI) focused NVIDIA Corp (NASDAQ:NVDA) whose stock has trebled over the past year. Hopes of interest rates cuts and a more resilient economy than expected have also boosted sentiment.

“The Magnificent Seven have been compounding earnings at anything between 15% and 20% per annum since the Great Financial Crisis. Technology and US leadership in that space, more recently AI, has been a huge underpin,” said Dan Cartridge, fund manager at Hawksmoor Fund Managers.

Turning to Japan, Cartridge says that wage growth has helped drive its consumer sector higher but it is the nation’s corporate governance reforms – partly aimed at driving higher corporate returns - which have been pivotal. “This includes the Tokyo Stock Exchange telling companies that if they are trading on a price to book ratio of less than 1x they have to explain why,” he said. “They have had to tackle their inefficient balance sheets.”

Frédérique Carrier, head of investment strategy for RBC Wealth Management in the British Isles and Asia, said Japanese companies as a result have adopted more shareholder-friendly measures, improving disclosures, growing dividends and announcing share buyback programmes.

Many companies, she said have also come under pressure to divest under-performing assets and to disentangle cross shareholdings structures - where companies own shares of other companies - freeing up capital that can be used to improve returns. Toyota Motor Corp ADR (NYSE:TM) reducing its stake in telecoms company KDDI is one such example.

Another key driver has been the return of inflation to a country almost synonymous with the term deflation. “This started about 18 months ago with investors calculating that it would mean companies putting up prices and boosting profitability,” she said. “Another factor in a world of increased geopolitical tensions is that Japan may be being seen as a proxy for investing in China.”

Plenty of optimism that Japan’s stock market party is just getting started

There could be more to come in Japan, with analysts such as Jesper Kroll of the Monex Group telling CNBC that the Nikkei could rise to 55,000 by the end of 2025.

Carrier says one driver could be a recent expansion in the annual investment limits of the Nippon Individual Savings Account, which was modelled on the UK’s ISA system. “For years, the stock market hasn’t been interesting to retail investors because it underperformed. But households hold huge amounts of cash, and this change could lead to higher inflows,” she said.

In terms of sectors expected to do well going forward, Carrier says select financial stocks could benefit from slightly higher interest rates. That follows the Bank of Japan’s historic decision to narrowly raise rates last month.

Cartridge said investors should look at Japanese small-caps amid the improvement in corporate governance. “You could buy Japanese small-caps at close to all-time low valuations with decent earnings growth catalysts in there,” he said.

In Hawksmoor’s Global Opportunities Fund, he highlights holdings such as M&G Japan Smaller Companies, Polar Capital Japan Value to capture the corporate governance play and investment trust Nippon Active Value Ord (LSE:NAVF).

Richard Aston, portfolio manager of the CC Japan Income & Growth Ord (LSE:CCJI), said investors should be excited by the potential for further earnings growth in Japan.

He said: “We believe that growth is set to continue with people spending and investing more helping corporate profitability.

“Japan is also quite well positioned to benefit from the on-shoring of semiconductors production as a result of geopolitical shifts and supply chain issues. Companies such as Taiwan Semiconductor Manufacturing Co Ltd ADR (NYSE:TSM) and Samsung Electronics Co Ltd DR (LSE:SMSN), as well as Japanese firms like Rapidus are making huge investments.”

Helping Japan catch up with global digitalisation trends, such as digital banking and a national aim to become the world’s most cashless society, are also key policy drivers creating investment opportunities, he added.

“Service industries face a challenge from rising wages, but at the same time a more elderly Japanese population is more likely to spend their money there than buying goods,” said Aston.

He added: “They may splash out in the leisure and domestic tourism sectors, and we are seeing investment in areas such as hotels, ski resorts and even stargazing activities.”

But despite this he believes some investors are still to be dazzled by Japan. “The scepticism is thawing but it is still there,” he said. “We like to think what we have seen is just the start.”

But there are reasons to be bearish on Japan

Matthew Page, portfolio manager of the Guinness Global Equity Income fund, which has over 50% exposure to the US, but none to Japan, is a clear sceptic. He said: “We look for companies with consistently high return on capital and while Japanese companies are improving on that front, the ones who do have that characteristic tend to trade at quite a substantial premium. We think we can find better valuations elsewhere.”

George Lagarias, chief economist at Mazars, warns of the impact of a stronger yen on earnings and by extension purchases of Japanese stocks. “If the Bank of Japan accelerates interest rate hikes, then I don’t expect this rally to last,” he said.

Cartridge acknowledges that a stronger yen might hit Japanese exporters, but that would further strengthen its focus on smaller more domestic-facing firms.

US v Japan: which market offers the best value?

However, he is finding much more value in Japan than in the US. He said: “We are far more positive on Japanese equities going forward than the US. That is down to valuation. Although we’ve seen some multiple expansion in Japan, it is from a very low base,” he explained.

He added: “In the US, we are underweight because very high valuations lead to poor subsequent returns unless you have huge upside surprised in earnings. We’ve had that impetus from AI, but will it continue?”

He said that US-focused investors “taking profits at all-time highs isn’t the worst thing they could do when there are lots of other global opportunities to exploit”.

Lagarias is also cautious about the US. “With the economy slowing down and with tech trading at 37 times its earnings, you don’t see any compelling valuations. This rally doesn’t have legs and the lack of fundamentals driving it makes investors like me apprehensive,” he said.

He added: “If you want to play positive sentiment, then play it. Or do you wait for the fundamentals to become more important again? If you are truly a long-term investor you will find opportunities, but I believe this is a time for more active investing not blindly following the index.”

Why US tech rally is staying power 

Page agreed that tech valuations are high relative to their recent 10- or 15-year history but “nowhere near dot-com bubble levels”.

He said: “Arguably, we have got a period of growth coming through in tech such as semiconductors, which is far more real and tangible than the dot-com drivers.

“Semiconductors has the AI theme as a tailwind but also a cyclical recovery having been in oversupply post-pandemic.”

He also highlighted the impact of potential US interest rate cuts this year on consumer spending helping previously unloved consumer staples stocks.

“We are most eagle-eyed on the state of the consumer’s balance sheet and credit card data. We are a little more bearish there. But overall, the odds are we are due a 10% correction every 12 months. So [even with the Magnificent Seven], it is not like I would be going all guns blazing into these momentum plays at the moment,” he stressed.

“But in terms of the direction, with the market already having priced in the US election this November, the outlook is positive.”

Carrier is also encouraged by the broad performance of US stocks, such as industrial, financials and consumer. “We are committed to US equities. Valuations are elevated but that doesn’t mean they can’t go higher,” she said. “Even if there was a retrenchment, we don’t think that would be the end of the bull market. The usual precursors of a bear market such as deteriorating market breadth where fewer stocks experience a price gain, are not there. Having said that, the probability of a shallow US recession remains uncomfortably high, so we will be cautious on stock selection and only focus on high quality.”

She said US investors who have made hay in the past few months could look to “trim” their holdings and take some profit if positions have become outsized but “there are still gains to be had. You don’t want to be out of the market. It is very difficult to get back in.”

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

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