Overseas investors increasingly see Japanese equities as undervalued and stable amid global uncertainties, including the rising trade tensions between the U.S. and China.
The Nikkei average closed at 24,120.04 on Friday, rising as much as 2% at one point to a midday 27-year high.
Funds have flown into Japanese shares since mid-September as U.S. stocks have climbed into record territory. Encouraged by the strong American economy and brushing off the Trump administration's trade war with China, investors have sent U.S. stocks higher while snapping up Japanese shares as bargains. The Nikkei is now flirting with its highest level since November 1991.
Concerns are growing that the U.S. market is overheating. Against this backdrop, "investors are diverting funds to Japanese equities, which are more undervalued than those in the U.S. and more stable than those in emerging countries," said Yasunori Iwanaga, chief investment officer at Amundi Japan Holding.
The Dow Jones Industrial Average climbed 5% from the end of last year through the end of August while the Nikkei average edged up just 0.4%. The tables turned this month, however, with the Nikkei jumping 5% compared to the Dow's 2% gain.
The Japanese economy appears headed for its longest postwar growth streak. But concerns about a slowdown also remain strong. "We were searching for a reason not to buy Japanese shares," said an analyst at one foreign securities company.
But these investors now feel confident about Japanese companies' earning power. Sony stock, for example, closed up nearly 5% Friday. Structural reforms helped the company post its first record operating profit in 20 years in fiscal 2017.
Pretax profit at Japanese companies, excluding the finance and insurance sectors, totaled 83 trillion yen (US$ 731 billion) in fiscal 2017, a 150% increase from fiscal 1991, government statistics show. The current fiscal year is also shaping up to be another record for corporate Japan.
Poor profit margins and low capital efficiency have long plagued Japanese companies, but these metrics are now improving. Pretax profit margins were 5.4% in fiscal 2017 compared to 2.3% in fiscal 1991, rising to 7.7% in the April-June quarter. Return on equity also hit the 10% mark in fiscal 2017, gaining ground on the U.S. at 18% and Europe at 12%.
Overseas investors are also re-evaluating their views of corporate Japan's long-term growth prospects. Improvements in capital efficiency will accelerate going forward as Japanese companies invest in information technologies and automation to cope with labor shortages, said Jonathan Garner, chief Asia equity strategist for Morgan Stanley.
Garner expects corporate Japan's return on equity to reach 12% by 2025. Morgan Stanley has upgraded its view on Japanese equities from underweight to neutral.
The results of governance reforms are gradually showing, said Keith Truelove at UBS Securities Japan, adding that doubtful investors will begin to move if Japanese stocks continue their ascent.
A soft yen is also raising expectations for stronger earnings. Although profit for the year ending March 2019 is expected to decline slightly, most companies based their forecasts on a strong yen. Profit may rise, however, should the yen continue to trade at around 113 to the dollar, far weaker than most assumptions.
A Daiwa Securities survey of 117 companies found that 94% assumed a rate stronger than 110 yen per dollar. Pretax profit growth could receive a boost of several percent because every 1 yen weakening against the dollar raises the figure by about 0.5%.
Toyota Motor's group operating profit is believed to increase 40 billion yen for every 1 yen weakening. The automaker's assumed rate for the full year ending March was 106 yen to the dollar, 5 yen stronger than fiscal 2017. This was expected to depress profit by 225 billion yen, but that forecast is likely to be significantly off should the yen remain weak.
The U.S.-China trade war still looms, however. The International Monetary Fund estimated in July that the dispute could shrink global gross domestic product as much as 0.5%. BMW just lowered its 2018 earnings forecast Tuesday because of the trade war.
Although Japan escaped additional U.S. auto tariffs after a summit in New York on Wednesday, Toyota shares have sunk 1.6% since late last year, while Nissan Motor is down 5%, despite 6% growth for the Nikkei average.
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