Analysis of Japanese Equity Market vis-a-vis China

While recent news of a potential debt deflation loop in China’s equity market is causing concern for investors, Japan’s equity market resilience may bring optimism.

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Welcome to Thoughts on the Market. I'm Daniel Blake from Morgan Stanley's Asia and Emerging Markets Equity Strategy team. Along with my colleagues, bringing you a variety of perspectives, today I'll discuss the Japanese equity market vis-a-vis China. It's Thursday, August 31st at 9 a.m. in Singapore. 

We recently did a three part series on this show focusing on our economic and market outlook for Japan. We discussed a bullish view on Japan equities, which is driven by three powerful drivers of outperformance coming together, namely macro, micro and the transition to a multipolar world. 

Recently, however, there's been investor concern about the potential impact on Japan from a Chinese debt-deflation loop, that is a scenario where prices fall, debt rises and economic growth stagnates, and this is the risk that I will discuss today. 

As a reminder, our economists came into 2023 flagging Japan as a standout developed market for growth momentum. In contrast to a U.S and European slowdown, as Japan continues to benefit from COVID reopening, ongoing stimulatory policy and a competitive currency. Since then, we have seen upside surprises, such as in wages and capital investments amid what we see as confirmation of a move into a structurally higher nominal GDP growth path. 

Indeed, Japan's recent second quarter GDP figures confirmed that trend, with a surge in real and nominal GDP to 6% and 12% annualized respectively. Following this result, our economists have doubled their 2023 GDP forecast to 2.2%, and this stands in contrast to China's GDP growth trend, where our economists have been reducing forecasts and will see nominal GDP growth slow below that of Japan to 4.8% over the last year. 

So the key exception to a generally bullish picture for Japan has been its linkages to China. While this may appear to be a legitimate investor concern for the market as a whole, it's important to note that Japanese revenues are driven much more by the U.S and Europe, which together make up a quarter of total sales. Instead, China makes up just 5% less than many assume, and far lower than that of Singapore, Taiwan, Australia or South Korea. However, there are some pockets of China exposure that we note, including in semis and semi-cap equipment, electronic components and factory automation. 

Another reason for our optimism about Japan's equity market resilience amid the slowdown in China is that China exposed Stocks in Japan have almost fully unwound the outperformance seen during the early COVID zero and post-COVID reopening phases. In contrast, Asia-Pacific ex-Japan companies with high exposures to China, many of them in the technology or resources sector, stand close to their relative highs. 

So while we do see from here less upside to the aggregate MSCI Emerging Markets Index and the Tokyo Stock Price Index, known as TOPIX, after the post October rally, we do see good reason for Japanese equities to continue to outperform. Valuations on a 12 month forward basis are in line or slightly below their ten year historical averages, and we expect 10% earnings growth in 2023 and 2024 as that nominal GDP growth recovery and corporate reform rolls through the market. The key downside risk will, of course, be not just the Chinese debt deflation loop, but adding on top a US recession, which ironically would be similar to what happened in the 1990s, when in Japan, imbalances, excess leverage and insufficient policy stimulus tipped the economy into structural deflation and stagnation. So while that risk is more relevant for China and Japan is in a completely different situation now, we are closely monitoring the risks of this bear case scenario and what that would mean for parts of the Asia and emerging markets universe. 

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