Absent the major reform investors have been hoping for, Japan’s economy remains largely stagnant, with the yen weakening against the U.S. dollar over the last quarter of 2016. By contrast, China, along with the rest of Asia, seems poised for another year of relatively stable growth. The policies of U.S. President Donald Trump, however, could potentially spur volatility in both economies. Let’s take a closer look.
Japan: Abenomics continues to fall short
The yen experienced wide swings during 2016. After strengthening about 16.5% in the first nine months of the year against the U.S. dollar, the yen reversed direction and weakened more than 15% against the U.S. dollar during the last quarter.1
Because a weak yen has typically driven exports and the Japanese economy is export-driven, this trend propelled the market during the fourth quarter. Investors outside Japan, however, did not experience the full benefit. Case in point: Although the Nikkei 225 Index was up more than 16% in yen terms during the fourth quarter, its return in U.S. dollars rose only a little more than 1% and its return in Canadian dollars rose a little over 3%.1
Why did the yen weaken so much during the last quarter? While global interest rates are expected to move higher due to rising U.S. interest rates, we expect Japanese interest rates to remain stagnant. That differential in interest rate expectations weakened the yen.
Viewed through our Earnings, Quality and Valuation (EQV) filter, earnings revisions for Japan were only slightly positive during the last quarter. That’s because improvements were mostly due to yen weakness, rather than corporate quality. Quality is difficult to find in Japan. Return on equity (ROE)2 for the MSCI Japan Index is still below 10%, compared with ROE of more than 20% for Invesco International Growth Class.3
The Invesco International and Global Growth team hasn’t changed our outlook on Japan. Abenomics – shorthand for the economic policies of Prime Minister Shinzo Abe – hasn’t worked effectively, and fiscal stimulus and monetary policy have been taken to the limit. As a result, we still see very little scope for improvement without major reform.
China: Transition creates optimism
Barring any major disruption from President Trump, China may be heading into another year of relatively stable growth in 2017. Forward gross domestic product estimates have been revised upward to 6.5%.1 Although revenue and earnings revisions for China were up slightly during the fourth quarter, earnings growth is expected to accelerate. Specifically, China had negative earnings growth in 2015 and flat growth in 2016; for 2017, expectations are for double-digit growth.4
More broadly, over the longer term we are generally optimistic about China as it transitions from an export-driven economy to a more services- and consumer-driven economy. China’s economy has historically been driven by fixed-asset investments, such as infrastructure, and exports. The peak of the fixed-asset cycle has passed, so there is good reason for China to transition to less volatile, more internal growth drivers.
In addition, we’re seeing the policy impact of consumer product consumption in the growth of the services, education and health care sectors, for example. In our view, this natural maturation of the economy is a positive transition for China that will drive the economy for many years.
But there’s a shorter-term caveat: President Trump’s rhetoric, which we view as a strategy to bring China to the table to renegotiate trade policy, has been critical. What could this mean for the market? While it’s anyone’s guess how trade negotiations will ultimately turn out, volatility is probable.
For us, that creates potential opportunity to find high-quality investments at cheaper valuations. As always, we stay focused on our fundamental, bottom-up approach to selecting stocks for our investors.