Japanese stocks don’t care about recession

Good morning. Yesterday Salesforce announced it would start paying a dividend, which struck me as a bit of a moment for what was once one of the great go-go growth tech stocks. Is the fun over? But Howard Silverblatt of S&P Dow Jones Indices reminded me there was a similar is-growth-dead moment when Microsoft paid its first dividend in 2003. That company’s stock was $24 back then. It closed yesterday at nearly $408. Dividends and growth can go together just fine. Email us: robert.armstrong@ft.com and ethan.wu@ft.com. 

Japan equities: what recession?

If over the span of six months US gross domestic product fell from 6 per cent growth to below zero, how would stocks take the news? Panic selling? Speculation about the Federal Reserve riding to the rescue? A rally in quality and defensives? 

However you imagine it, stocks breaching all-time highs probably isn’t on your list. Yet that’s what is happening in Japan. A roaring 6 per cent annualised GDP number in the second quarter of 2023 turned out to be a headfake and the next two GDP reports came in negative — the loose definition of a technical recession. At the same time the Nikkei 225 has recently surpassed the 1989 bubble peak (the Topix has a bit left to go). Japan’s three decades without an all-time high is a rare feat for postwar stock markets, as this chart from Deutsche Bank’s Jim Reid shows:

Why have Japanese stocks been so blasé about recession? Our intuition from US stocks is that negative growth creates earnings weakness, which then drags on stock prices. What link in that chain is different in Japan?

Start first with the growth picture. Because Japan is a low-productivity economy with a shrinking labour force, its baseline growth potential is meagre. The Bank of Japan’s estimate of potential GDP, the equilibrium growth rate of the economy, is less than 1 per cent a year.

A 1 per cent rate leaves little margin for error, so small shocks can make the difference between growth and contraction. The striking result: in 17 of the past 18 years, Japan has contracted for at least one quarter, and often two, note Alejandra Grindal and Patrick Ayers of Ned Davis Research. Recessions are just not much of a market event; stocks don’t react predictably to them. Recession aside, the Japanese economy has actually beaten consensus expectations. The Japan Citi economic surprise index has picked up lately, thanks to low unemployment and resilient business sentiment (orange line in NDR’s chart below):

Meanwhile, corporate Japan is doing well enough. Listed manufacturers grew earnings 21 per cent over the three most recent quarters, finds Nikkei Asia. Forward earnings estimates for the Topix have powered higher over the past year, lifted by a historically weak yen:

Earnings per share has been boosted not just by better-than-feared economic data, but also the slow roll of corporate governance reforms. Return on equity has nudged up, from about 8 per cent in early 2023 to 10 per cent this month. That’s still short of other big markets (Europe’s Stoxx 600 trades at a 13 per cent ROE), but the direction of travel is right. Seemingly every few weeks we are treated to a fresh story of a bloated Japanese company facing activist demands, returning money to investors, or shedding non-core assets. Two examples from this month:

[February 28:] Four major Japanese non-life insurance companies will sell their entire cross-shareholdings worth about ¥6.5tn (about $43bn) over the next few years, following a price-fixing scandal that has heightened scrutiny of their business practices . . . 

[February 4:] Elliott Management is calling for Japan’s biggest property group, Mitsui Fudosan, to launch a ¥1tn ($6.8bn) share buyback as the US activist fund targets the most prestigious end of the Tokyo stock market.

Elliott’s demands — presented to top management within the past month — include a request that the company sell down its $3.6bn stake in Oriental Land, the company that runs Tokyo Disneyland . . .  

Against low expectations, Japan is still outperforming, recession or not. (Ethan Wu)

Fundamentals are fine — just fine 

We are hearing a lot of talk — heck, we have talked some talk — about how the recent surge in the stock market is grounded in strong earnings. The fundamentals are so strong right now, some argue, that elevated valuations are not anything to worry about. Bank of America strategist Savita Subramanian made the case yesterday on CNBC. Yves Bonzon of Julius Baer made it yesterday in the pages of the FT: 

Today’s equity market rally has been underpinned by robust earnings and record production of free cash flow . . . Investors who conclude that US large-cap equities are overvalued are implicitly discounting that free-cash-flow metrics, which have improved sharply in recent decades, will return to their long-term weaker mean.

I don’t think that Subramanian or Bonzon or the others taking this view are wrong, exactly, but I think one needs to be very careful. It is one thing to note that there seems to have been a regime change in valuations sometime in the 1990s, so that using very long-term valuation averages to argue that stocks are too expensive today is not a good idea. You can see this (possible) regime shift, for example, in Robert Shiller’s famous chart of cyclically adjusted PE ratios. I have indicated it with a wobbly black line:

Both Subramanian and Bonzon seem to hold the view that there was a shift in valuation regime shift about 20 years ago, and I think they could be right about this (it might have something to do with the sector composition of the index, or interest rates and inflation, or somethings else). But it is another thing altogether to say that fundamentals are very strong right now, justifying a big market move and unusually high valuations relative to the recent-ish past. This may be true for a few companies (all together now: Nvidia!) but for stocks more broadly, I can’t see much evidence for it. 

Look at large-cap earnings. FactSet, for example, estimates that when all the fourth-quarter results for S&P 500 companies are in, earnings for the index will be up about 3 per cent from the year before, and full year 2023 earnings growth will land in the low single-digits, too. The 20-year average growth rate for earnings is about 10 per cent (according to S&P Indices). That said, 2021 and 2022 were pretty hard acts to follow, earnings-wise, and next year Wall Street’s bottom-up estimates are looking for a return to 10 per cent growth in 2024. It’s worth noting, though, that those estimates for 2024 earnings have not risen at all over the past 12 months, despite Nvidia and everything else.

This is not bad. It’s all fine, in fact, and the strong US economy suggests that it should continue to be fine, at least for the next few quarters. But fine is all it is. The US is not in any sort of generalised earnings boom. 

One good read

We’ve been feeling our worry levels on commercial real estate creep up. So this piece by Alexandra Scaggs at Alphaville was a nice salve.

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