Japan’s fading rally drives some investors to cheap China shares
JAPANESE stocks have trounced their Chinese peers this year, but some investors are betting the tide is about to turn.
Headwinds are growing for Japanese equities including deteriorating global growth and concern the era of yen weakness that has bolstered exporters’ earnings may be nearly over as the central bank comes under pressure to tighten policy.
Conversely, optimism is building that Beijing’s efforts to bolster the economy and local equity markets will help end a slump that has made Chinese equities among the world’s worst performers this year. Historically low valuations are also set to lure bottom fishers.
“The relative outperformance in the next 12 months will come from the likes of China or China-centric type of economies,” said Jun Bei Liu, a fund manager at Tribeca Investment Partners in Sydney. “Japan is an easy one” to fund the trade after its huge outperformance this year, she said.
Japan’s Topix index has jumped 23 per cent in 2023, heading for its best year in a decade, as economic growth accelerated and efforts to improve corporate governance lured investors. Meanwhile, China’s benchmark CSI 300 has slumped 7.4 per cent as a faltering economy dashed optimism over the nation’s reopening from Covid restrictions and the ailing property market has yet to recover.
There are signs that Japan’s outperformance may have peaked.
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The Topix is already more than 4 per cent off its high for the year as rapid global interest rate hikes worsen the outlook for external demand, which would hurt Japan’s industrial powerhouses. Export-reliant industrials make up about a quarter of the index, a larger proportion than in the Chinese benchmark.
Japanese stocks are also smarting from their high correlation with the S&P 500 Index, which entered a technical correction last month. The Topix and S&P 500 have had a weekly correlation of 0.57 over the past decade, while that between the CSI 300 and S&P 500 was just 0.1. A reading of 1 would mean the two moved in lockstep.
Another risk for Japanese shares is the heavy positioning by global funds. Overseas investors have bought a net US$30.7 billion of local stocks this year through Oct 27, on track for the biggest year of purchases since 2013.
“Global funds are highly exposed to Japanese equities, much more so than in the last decade,” HSBC Holdings strategists Herald van der Linde and Prerna Garg wrote in a research note last month. “So there’s limited room to increase their holdings.”
The bank is underweight Japan and overweight mainland China, they said.
Yen danger
Any downdraft in Japanese stocks may accelerate if the yen starts to strengthen. The currency has plenty of room to appreciate as it’s tumbled almost 13 per cent this year and is close to a three-decade low.
While the Bank of Japan disappointed yen bulls last week by only modestly tweaking its yield-curve-control policy, it did take a step in that direction and a more substantive move would boost the currency.
Among positive factors for Chinese equities is the attractive outlook for earnings. Companies in the CSI 300 Index will see earnings grow an average 22 per cent over the next 12 months, according to forecasts compiled by Bloomberg. That compares with just 5 per cent for constituents in Japan’s Topix.
Valuation metrics also suggest Chinese equities have room to rebound. The CSI 300 Index is trading at 10.5 times forward earnings, below its five-year average of 12.4 times. The Topix trades at 14.3 times, in line with its five-year mean.
“In a correction, China should hold better than other markets in Asia due to light positioning and cheap valuations,” said Luca Castoldi, a senior fund manager at Reyl Group in Singapore. Japan on the other hand is likely to follow the US going forward, he said.
Reyl is looking to add to its holdings in China while being short Japanese stocks and long the yen, he said.
Choose carefully
Even though there are plenty of reasons for Chinese shares to outperform their Japanese peers, seasoned investors say the challenging global investment landscape still calls for careful stock picking.
“There are a lot of opportunities in the Chinese market because it is such a deep market, but you need to stay selective,” said Fabiana Fedeli, chief investment officer for equities, multi asset and sustainability at M&G in London. The money manager has been increasing positions in China in recent months, she said.
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