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Are we going Japanese? No doubt fed-up with being asked that question in client meetings, Citigroup strategist Robert Buckland has set out to find the answer.
He has examined the Japanese bear market, which started back in 1990, and come to the conclusion that while there are parallels, equity markets in the developed world aren’t facing the same dire combination of weak economic growth, falling corporate profits and earnings dilution.
Which is just as well — because Japanese equities are down 69 per cent since their December 1989 peak. World-ex Japan equities are only down just 28 per cent since their March 2000 peak.
First, the back story:
(emphasis throughout ours)
Japan sends a stark warning to contrarians. Just because equity prices have fallen for a decade, do not assume that they will rise for the next. Indeed, the bears have drawn comparisons between Japan and the outlook for other developed equity markets from here. Charts overlaying asset performance of post-1990 Japan and post-2000 elsewhere have become especially popular. The parallels are evident: bursting asset price bubbles, deflation fears, ultra-low interest rates, fiscal problems, fragile banking sectors, slowing consumer spending, ageing populations and rising savings ratios. The list is long and the investment implication apparently obvious. If the US and Europe are heading for Japan-style stagnation, then their equity markets should be avoided for the next decade as well. Stick to government bonds instead.
And now Buckland’s findings.
In reaching his positive conclusion, Buckland breaks the Japanese bear market down into its key drivers – de-rating of equities, weak economic growth, poor earnings and shareholder dilution – and compares that to now:
Our analysis suggests that the Japanese bear market has been driven by four factors: a violent de-rating in 1990-92 and then weak nominal GDP growth, a falling earnings share of GDP, and EPS dilution afterwards. For the US and Europe we also believe that the de-rating was largely completed some time ago. From here, we think that it is unlikely that we will see a similarly dire mixture of weak economies, falling corporate earnings/GDP ratios and EPS dilution. Even if economic performance is much weaker than we expect, we think that companies can and will increasingly turn to de-equitisation to support shareholder returns. Japanese companies have generally failed to do this in the past 10 years.
Indeed, Buckland thinks the case for de-equitisation in developed markets is particularly compelling:
Of course, all forms of de-equitisation are down sharply from their 2007 peaks. However, there are signs that they are coming back, especially in the US and Europe. The arguments for a pick-up in global M&A look compelling7. There have been 3 cash bids for UK mid-caps in the past week alone. Cash-rich US companies continue to announce enhanced buyback schedules.
A return to de-equitisation now seems likely in markets outside Japan. Cheap equity valuations and negligible cost of cash financing mean that buybacks and cash bids should be highly earnings accretive. As importantly, de-equitisation should provide net buying for developed market equities at a time when weak fund inflows suggest that they remain unpopular with conventional investors. This should be a support for global share prices, even if we do see economic stagnation from here.
So too the outlook for economic growth and earnings:
The Japanese experience suggests that once the valuation bubble has burst, market direction largely comes down to EPS. The first driver of this is nominal GDP. Over the next five years, Citi economists expect nominal GDP increases of 12% in Japan, 16% in Germany, and 28% in the UK and US. That's a reasonable, if not spectacular, starting point for corporate managements to work with. These forecasts certainly do not imply a double-dip in the global economy.
How might we expect companies to leverage this economic outlook (the earnings/GDP ratio)? This is largely a function of their ability to drive up profit margins or find new revenue streams, often overseas. It is something that Japanese companies have struggled to do over the past 20 years. However, the evidence has been more encouraging elsewhere. For example, US companies have been very successful in cutting costs to maintain profit margins. Our analysis suggests that the big UK and German companies that dominate the local equity indices are more plays on global than domestic GDP5. They generate significant earnings from outside Europe (50% for UK, 40% for Germany). With global nominal GDP growth of 36% forecast over the next five years, the prospect of stagnant revenues seems unlikely.
Let’s hope so.
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