End of deflation foreshadows a bright future for Japanese equities

But dig a little deeper, and an altogether different picture emerges, said Adrian Hickey, head of Japanese equities at Pictet Asset Management (PAM).

“After having dragged their heels for many years, policymakers and Japanese companies in particular are at last doing what is required of them to place the economy – and the stock market – on a path to a strong recovery,” he said.

Mr Hickey explained that a strong potential boost to Japanese equities comes via the country’s central bank, which earlier this year set itself an explicit inflation target in a bid to end deflation, and also announced plans to extend its quantitative easing programme to boost the flow of credit to households and businesses.

The early signs are that such moves have met with success, Mr Hickey said, pointing to the fact that market expectations for inflation – as measured by the gap in the yield between inflation-linked and nominal government bonds – point to a steady rise in inflationary pressures over the next five years.

The official inflation data tell a similar story. Headline inflation - which includes food and energy prices – recently moved into positive territory while core inflation has shown a marked deceleration in price declines. A narrowing of Japan’s output gap, meanwhile, also suggests that deflationary pressures are fading – “a good sign that the excess capacity that has so long plagued the economy is finally being removed”, Mr Hickey said.

The BoJ’s successes also extends to the currency markets. Here, the central bank’s aggressive monetary easing has helped stem an appreciation in the yen, which should brighten the earnings prospects for Japan’s export-dependent companies, he said.

The central bank’s monetary stimulus coincides with the disbursal of public funds that will go towards the reconstruction of areas devastated by last year’s earthquake and tsunami. The government’s 19 trillion reconstruction programme is expected to lift economic output by some 1.7% in 2012, according to official forecasts, and create around 600,000 new jobs.

Corporate Japan is also moving in a positive direction, said Sam Perry, a senior Japanese equity investment manager at PAM. As firms continue to recover from the devastating effects of last year’s natural disasters, corporate earnings are expected to rise by an annual 28% over the next two years, he said. What’s more, companies are also starting to put the large amount of cash they have accumulated over the past several years to more effective use.

“Since 2011, Japanese wages have been showing signs of life,” Mr Perry said, referring to data showing that earnings among companies with more than 30 employees are rising at an annual rate of 1.5%.
Also encouraging is the fact that Japanese firms are offering better rewards to their shareholders, he added.

The dividend yield on companies in the TOPIX is a respectable 2.2 per cent, and is projected to rise to 2.6 per cent in 2012. “This compares well to a dividend yield of just 2 per cent for S&P 500 Index,” Mr Perry said.

Crucially for investors, these positive macro and microeconomic developments have yet to be reflected in equity market valuations. In aggregate, Japanese stocks are trading at a price to book ratio of around 1. This is an unjustifiably low level, especially when taking into account the high volumes of cash companies have accumulated on their balance sheets.

For those on the hunt for value, Japan merits a second look.