Goldman Tells Why Americans Are Ho-Hum on Japan Stock Rally

(Bloomberg) -- Japan's stocks are on a roll this year, but even with a stronger yen to boost returns in dollars, Americans aren't impressed.

"Overall interest in Japanese equities was fairly subdued during our recent U.S. marketing trip," Goldman Sachs Group Inc. analysts Kathy Matsui, Hiromi Suzuki and Kazunori Tatebe wrote in a June 1 report. "Most long-only U.S. investors remain underweight Japan."

They would have been missing out on Friday, when the Topix index closed at its highest level since August 2015. The gauge as of Monday's close has a total return of 7.1 percent for 2017, or 13 percent in dollar terms. By comparison, the S&P 500 Index's return is 9.9 percent this year. Also eye-catching: the Nikkei 225 Stock Average has surpassed 20,000 for the first time since 2015.

Among the reasons the Goldman strategists listed: concern among U.S. investors that "Japanese economic reform momentum is taking a backseat to constitutional revision." At issue: Prime Minister Shinzo Abe's effort to amend the country's pacifist constitution to include recognition for its self-defense forces has split the public and threatens to take over the political agenda.

Yet even with the controversy, few expect Abe to lose office for years to come. And Matsui highlights Abe cannot elevate Japan's geopolitical stature without a growing economy behind it.

Another challenge has been a continuing association of the Japanese market with the yen. As investors can readily see on certain days, when the yen falls, the Topix index tends to rise -- thanks to the assumption a more competitive currency would inflate exporter earnings. What that narrative misses is a subtle change in Japan's domestic market, with the economy gradually shedding the legacy of deflation after a plunge in the unemployment rate.

"It was just hard to get people excited about the market unless you could paint a picture that the yen was going to fall significantly," Matsui said by phone describing her trip in late May to meet with dozens of investors in several U.S. cities. She and her team highlighted in the report that exports make up less than one-fifth of gross domestic product. "They will eventually get it, but they still need convincing."

Other reasons the Goldman team cited for American investor indifference to Japan's equities:

• Greater focus on European stocks within developed economies, especially after the French presidential election, and on Asian emerging markets including China and South Korea.
• The recent drop in U.S. Treasury yields -- a development that could weigh on the dollar against the yen.

Foreigners have become modest net investors in Japanese stocks this year, but that's been propelled by Europeans, according to Goldman. "It is difficult to identify catalysts that will lure significant foreign buying in the short-run," they warned. That's especially true for Japan's Pacific partner: "one reason cited by U.S. investors for staying on the sidelines of the Japanese equity market is that they are at a loss as to where to invest within the market."

If Japanese stocks are now less of a play on the basis of swings in the yen, investors may need to do more leg-work on which sectors are set to benefit from underlying changes in Japan's economy -- and in particular the gradual shift toward sustained wage gains.

Goldman, along with Morgan Stanley and Bank of America Merrill Lynch, have all published research in recent months flagging stocks that are poised to outperform as companies cope with deepening labor shortages -- read more about that here.

"Until now, there's been a bearish interpretation of job-market tightening -- that the benefits would go more to the workers than to shareholders," Matsui said. "We're still in the very early stages, and have to wait and see how this pans out, but we are encouraged" that some companies will benefit.

To contact the reporter on this story: Christopher Anstey in Tokyo at canstey@bloomberg.net.

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Jeff Sutherland