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Asia Pacific Intelligence

Allocation to alternatives by Japanese institutions set to increase as domestic market booms

Thursday, May 09, 2013

Two pieces of research into Japanese institutional investment, one from JP Morgan Asset Management, the other from the Nomura Research Institute, show that alternative investments are set to gain in popularity.

Patrick Moonen

The JP Morgan survey, conducted between April and early March 2013 summarises and aggregates the responses obtained from 128 pension funds. Investments in alternatives saw the biggest rise from 8.3% to 10.6% according to the survey results, at the expense of domestic equities and bonds. The survey puts this down to a different climate in Japan with the quantitative easing policy of the Bank of Japan and Prime Minister Abe and the ultra-low interest rates in the "developed countries".

Institutional investors in Japan seek diversification but the level of assumed risk is bottoming out, the report finds. There is an increasing trend towards absolute return investments, particularly hedge funds, private equity and real estate. The report finds that investors are happier to adopt a more proactive strategy to achieve a higher return.

The JP Morgan report was covered in the blog attached to the Japan Pensions Industry Database, which warns that much of what the Japanese deem as 'alternatives', the rest of the world would consider as mainstream. The JPID blog also reviewed the Nomura report and forecasted that overseas firms would be the winners in receiving institutional money from Japan.

Abenomics, as the new economic policies of Japanese Prime Minister Abe are beginning to be known, are having a profound effect on the Japanese equity markets and gaining the attention of institutional investors from outside the country.

In an interview with Asia Pacific Intelligence, Patrick Moonen, Senior Equity Strategist at ING Investment Management reports that the Japanese equity market is one of the firm's most preferred markets. "Japan now has the best chance in more than a decade to leave the deflationary environment it has been in" he explains. "It is sustainable to continue with the loose monetary policy without limits until inflation reaches 2% - the Bank of Japan can continue buying Japanese government bonds."

It's not just the loose monetary policy but also relative earnings momentum in Japan that appeals to ING. Earnings momentum is at its highest level in almost three years whereas in the US, Europe and the emerging markets, earnings momentum continues to be negative. "This is a powerful factor behind the performance of Japanese equities" Moonen says.

The depreciation of the yen to an average of 95 against the dollar has encouraged earnings growth of over 40% to March 2014 and forward valuations that make Japan as cheap as Europe. "But here the Japanese central bank is more flexible than the ECB" Moonen comments.

The third element and consequence of Abenomics is that Japan is really getting the benefit of the doubt that economic growth figures will pick up later this year and into 2014, Moonen says. "These factors differentiate between the regions and Japan scores relatively highly on each of these factors."

In addition, Moonen believes that the Japanese market is a market that is to a large extent driven by positive price momentum and its 30% increase since the beginning of this year shows nothing but strength. Within their portfolios, ING has to take into account the weakening of the yen. "For a European investor the extra performance is eaten away by the weakness of yen but we always hedge 50% of our currency exposure to protect against that" Moonen says.

The firm remains positive on equity markets generally, Moonen says, "Despite some evidence of somewhat weaker economic data, the moderate uptrend remains in place. Of course, regional differences exist with the US and Japan showing better data than Europe."

In his report, Moonen writes: "The housing recovery in the US and the improved outlook for corporate investment plans are both supportive with the average age of the US machinery park increasing to the highest level in 30 years. This reflects past underinvestment as companies were in capital preservation mood and focussed more on debt reduction than on investment or expansion. The return of growth pushed up capacity utilisation and, in the past, this has always been a precursor of higher investments."

With respect to Europe, ING IM states that the continent is still somewhat weaker than other regions. However, support may come from an export-led recovery, helped by a weaker Euro and a global recovery, which is especially beneficial for Germany. Additionally, fiscal tightening should be less of a headwind in 2013. ING IM remains cautious given the continuous declining trend in credit to the non-financial private sector.

On the back of this, ING IM has upgraded its 2013 earnings estimates for Japanese companies from +37% to +41% and from +5 to +7% for US companies. The investment manager notes that listed Japanese companies are very export-sensitive and also tend to have a high operational leverage which means that even a small increase in the top-line growth leads to a relatively strong increase in net profits.

Patrick Moonen continues: "Another key element in our outlook is valuations. Absolute valuation metrics may be close to normal but, relative to other asset classes, they are still very attractive. The European equity risk premium increased in the aftermath of the Italian elections and the Cypriot bail out and is currently 6.7%, more than one third above its long term average. Meanwhile, the dividend yield compares favourably to the corporate bond yield.

"Another driver for equity markets is the recent rise in corporate activity; especially M&A and equity buy backs. We expect this trend to continue as all the necessary conditions are in place. Corporate balance sheets are strong, interest rates are low and companies can easily tap the high yield market to finance the deals.

"Next to this financial rationale, there is also a business rationale. In a low nominal growth environment, companies need to search for external sources of growth. Likewise, the high corporate margins leave not much scope for further autonomous operational improvement. Balance sheet restructuring is a way to achieve higher returns by lowering the cost of capital."

In terms of regional asset allocation, ING IM is positive on Japan, which delivers high earnings growth at a low price.  Furthermore, following the Cyprus deal, the investment manager increased the underweight in the Eurozone and prefers the US, despite its higher absolute valuations and lower risk premium.

With regards to the other regions, ING IM remains cautious on emerging markets with local companies struggling to transform superior economic growth into superior earnings growth.

Patrick Moonen concludes: "Looking at sector allocation, we have cut our commodity exposure by moving Materials and Energy to a small underweight. Overall, we maintain a small cyclical overweight.  Meanwhile, in March, we upgraded Health Care to a small overweight as the underlying fundamentals improved and the sector was cheap on prospective earnings."

 
This article was published in Opalesque's Asia Pacific Intelligence our monthly research update on alternative investments in the Asia-Pacific region.
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