An outlook for any major asset market likely involves QE, so a comment on such is firstly warranted. Clearly, it is wrong to state definitively that QE works or not in any given country, as one can only make an educated guess as to whether events would have been better or not, in sum, compared to a counter-factual estimate of what would have occurred without QE. In that sense, it seems QE has done far more good than harm for participating countries, especially when one recalls the dark days of 2009 and the various European crises.
More recently, QE (in either balance sheet holdings or new purchases forms) has helped counter one of the greatest deflationary factors in world history, which has occurred outside the control of central banks: shale drilling. Major technological inventions often cause boom and deflationary bust cycles, but have rarely, if ever, have affected the world’s most important commodity in such substantial way. The effect on the oil price did not occur immediately, but when it did, the 80% decline, also partly caused by geopolitically-driven factors, was astonishing. This is another reason to ignore those who state that QE failed to create inflation in Japan or elsewhere, as shale drilling was an uncontrollable external factor, and inflation would likely have been much lower without QE. Indeed, a global depression was a likely counterfactual scenario. One must also realize that deflation characterizes only commodity prices and quality-adjusted technology goods, whereas the most important asset class in the world, real estate, is quite significantly inflating, greatly due to QE’s effects.
In the current equity environment, one of the most important aspects of QE is its effect on corporate profits. Of course, forex rates are affected by QE, so the size of one country’s QE is important in relation to other countries’ QE, and the forex rate significantly influences corporate profits. In this regard, Japan has clearly benefited more than the West in recent years due to its massive QE program. QE also lowers interest costs, which usually increases capital expenditure and personal consumption, at least compared to what would have occurred without QE, which contribute to corporate earnings, as well.
With QE, the Yen reversed its overvaluation and confidence in general increased greatly. Asset prices, including equities, increased, partly due to increased valuation metrics, but mostly due to the rise in underlying earnings. Indeed, earnings growth expectations in Japan have remained high, while such in the US and Europe (not to mention emerging markets) have steadily declined. This is the key reason why Japanese equities outperformed global markets in USD terms in 2015 and will likely do so again in 2016, as the earnings expectation divergence trend seems to be accelerating, so it is important to understand all the reasons for corporate earnings growth in Japan.
Fortunately, Japan has relatively minor commodity-producing exposure, so its corporate profits have performed much better than European or American corporate profits during the commodity bust of the last eighteen months, as mining and energy multinationals comprised a significant portion of corporate profits in the West. Meanwhile, the effects of low energy prices have pummeled energy-based economic zones in the US, as have low agriculture prices in its farm-belt.
Similarly, parts of Europe have been hurt by lower energy prices and the region has been hit by the effect of mutual economic sanctions with Russia. Corporate profits in Japan have also benefited from lower commodity input costs, and perhaps as much as any country, Japanese consumers have benefited from lower import prices of such (although partly offset by a weaker Yen). On the converse, recent media reports and analyst commentaries are suggesting the ECB’s QE program has failed to lift profits, although it seems clear profits would have been much worse without QE and that much of the profit problem was commodity price-related and, thus, out of the ECB’s control.
Importantly, yet completely separate from QE or other global fundamental factors, Japan has structurally improved its corporate governance. As my earlier writings have indicated, this improvement began ten years ago, but only became widely apparent in the last few years, and was augmented even further by Abenomics (along with the beneficial political stability that he has brought). The effect on corporate profits has been very strong, and expectations by the market for continued profit maximization has also boosted intermediate-term earnings estimates, which are extremely important for equity valuations. As corporate governance improvement has become mainstream, we expect this trend to continue developing this year, as there is yet much more to accomplish.
In any market, corporate profits should be the main driver of equity prices as long as valuations are fair, and on this front, as commodity prices remain low and corporate governance remains strong, Japan’s earnings and earnings expectations should outperform those in the West. Since equity valuations are also more attractive than in the West, these two factors strongly suggest that Japanese equities should outperform global equities in the next six months. Japan does have high operational gearing due to lower profit margins than the West, so if there is a global recession, the equity outlook vs. global markets is not as strong, but still relatively firm, in our view.
John Vail is Nikko AM’s Head of Global Macro Strategy and Asset Allocation.
