Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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The boom in equities is coming to Japan, Arm sets new record on valuation
Peter Garnry
Chief Investment Strategist
Summary: Japanese equities are booming with strong gains in tech stocks and specifically Tokyo Electron up 13.3% due to strong semiconductor equipment demand in China. Overall, while Japanese equities look impressive in JPY, but their return is more modest compared to US and Europe in USD terms. The future path of JPY remains crucial for foreign investors. Another boom is going on in Arm shares gaining another 29% yesterday taking its valuation to unprecedented levels which are difficult to justify on fundamentals and likely is driven by FOMO.
A Japanese equities boom in JPY, not so much in USD
Sometimes you are right and sometimes you are wrong. We were clearly wrong on Japanese equities as we highlighted in our recent Quarterly Outlook that we liked UK and European equities over Japanese due to JPY appreciation risks. The idea was based on BOJ closing some of the gap to other central banks as continuously weaker JPY is unsustainable longer term. Was has in fact happened is the exact opposite with the JPY weakening this year against the USD. The flipside of this trend in JPY has been a continuation of the momentum in Japanese equities.
In today’s session, Nikkei 225 futures gained 3.4% led by strong gains across technology stocks with the information technology and communication services sectors up 5.7% and 3.6% respectively. Japanese banking stocks were also leading the gains up 4.3%. The strongest single stock gainer was Tokyo Electron up 13.3% as the company hiked its fiscal year guidance on strong demand from China with the country accounting for almost 50% of revenue in the quarter than ended in December. Demand for Tokyo Electron semiconductor machines are coming back as memory chip demand is rebounding as consumer electronics have turned a corner as inflation is no longer suppressing consumer demand. Tokyo Electron is also benefiting from various US semiconductor sanctions against China.
Japanese equities have returned 11.6% annualized since August 2012 when Abenomics was introduced which have created a sense of more optimism and strong wealth creation in Japan. While Abenomics have changed Japan lifting nominal GDP growth and increase women labour market participation, it is has also come with a structural weaker JPY. In fact, if one compared Japanese equity returns against US and Europe in USD terms then the Japanese total return falls to 7.7% annualized, only a bit better than Europe at 6.6%. The US equity return is still impressive at 12.9% annualized since August 2012.
When you look at the total return index of Japanese equities in JPY it looks like a bubble, but it is important to take a step back and look at valuation. The current dividend yield is 2.1% and the buyback yield is 1%, so Japanese companies are returning 3.1% of capital to investors. The long-term real GDP annual growth for Japan is estimated to be around 0.5-0.6%. Adding GDP growth takes the long-term real return expectations for Japanese equities to 3.7%. Adding back 1.5% annual inflation means that Japanese equities are expected long-term to deliver 5.2% annualized nominal return. Given that the JPY has depreciated annually by around 4% against the EUR since Abenomics, the future path of the JPY is key to take into account before foreign investors pile into Japanese equities.
Arm continues to defy gravity in financial markets
We wrote about the bonanza in Arm shares last week flagging the risks and basically warning investors to not be carried away. While Arm is an incredible company with strong IP rights and a deep moat against the competition the increased guidance is not high enough to justify such a big repricing of Arm. Investors are clearly not reading our warnings and Arm shares rose another 29.3% in yesterday’s session. It is clear that Arm is driven by a fear of missing out on another AI boom because objectively Arm is now valued at levels we have never seen before.
Arm’s current 12-month forward EV/sales* is 39.5x which is around twice the S&P 500 stock with the highest 12-month forward EV/sales which is Prologis at 19.8x. However, since this is a real estate company the ratio is not comparable. Let us compare it to some of the most richly valued technology companies in the S&P 500 Index. Nvidia is at 18.7x, ServiceNow is at 14.2x, and VeriSign is at 13x. In other words, Arm is valued at levels that we have never seen before since the raging bull market during the dot-com bubble.
EV means the enterprise value which is the market value of the company plus the net debt which is outstanding interest-bearing debt minus cash equivalents. The measure is used because it makes it possible to compare companies with different capital structure (the mix of equity and debt on the balance sheet).
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