From BlackRock: We see global reflation and a weak yen propelling Japanese stocks higher on a currency-hedged basis. Richard Turnill explains, with the help of this week’s chart.

We see a strong case for Japanese stocks on a currency-hedged basis, as this week’s chart helps explain. We believe they should disproportionately benefit from global reflation, as well as a potential pickup in Japanese growth ahead. A weak yen is a positive.

A falling yen helps the Japanese equity market in two ways. First, it boosts the earnings of Japanese exporters in local currency terms. This impact can be seen in the chart above, with forward earnings in Japan closely tracking the dollar/yen rate in recent years. Second, it makes Japanese assets cheaper for foreign investors, attracting capital inflows into Japan.

More than just yen weakness

We do see the yen’s slide slowing versus the U.S. dollar. Yet the currency is likely to remain weak as zero-anchored Japanese 10-year bond yields encourage local investors to buy higher-yielding foreign bonds. Beyond a weak yen, there are tentative signs local inflation may be picking up, with the biggest month-on-month spike in headline inflation seen in 25 years in October. Our BlackRock Macro GPS economic indicator also implies upside global and Japanese growth surprises could be ahead.

As a result, Japanese earnings estimates are rising. The three-month change in 12-month forward earnings estimates is near a two-year high. Japan’s relatively low corporate profit margins mean a given increase in revenues can have an outsized impact on earnings. A one percentage point increase in real global gross domestic product (GDP) growth has historically delivered a 21% boost to Japanese earnings, our analysis of the past 35 years shows, versus just 5% in the U.S. Japan’s political stability and creeping but underappreciated reform momentum also are positives, as are Bank of Japan (BoJ) equity purchases and rising corporate share buybacks and dividend payouts.

But there are risks, including a yen rebound, a growth slowdown in China, an unlikely change in BoJ policy before mid-year and longer-term worries such as a soaring debt load. For now, we see opportunities in Japanese exporters. Read more market insights in our Weekly Commentary.

iShares MSCI Japan ETF (NYSE:EWJ) was unchanged in premarket trading Tuesday. Year-to-date, EWJ has gained 3.38%, versus a 1.31% rise in the benchmark S&P 500 index during the same period.

EWJ currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #1 of 80 ETFs in the Asia Pacific Equities Ex-China ETFs category.

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This article is brought to you courtesy of BlackRock.

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