Should you invest in Japanese stocks? UBS answers

Japan's TOPIX index has reached new highs driven by renewed foreign buying, yet UBS maintains a 'Neutral' stance, advising caution due to stretched valuations and weakening profit forecasts. The firm anticipates downward revisions in upcoming June-quarter earnings, which, while negative in the short term, could establish a floor for expectations and potentially create opportunities in undervalued cyclical stocks like autos and machinery. While momentum-driven gains persist, UBS suggests a focus on risk-reward in undervalued, high-quality cyclicals for better medium-term returns, supported by potential corporate buybacks and resilient U.S. markets.

Analysis

Despite the Japanese TOPIX index breaking the 2,800 level on momentum-driven foreign buying, UBS maintains a 'Neutral' and cautious outlook on the country's equities. The core of this caution stems from stretched valuations in leading sectors, such as tech services and utilities, coupled with weakening profit forecasts. The upcoming June-quarter earnings season is positioned as a critical inflection point. UBS anticipates that widespread downward revisions to full-year corporate guidance, particularly from exporters, will be announced. While this represents a near-term negative, it is expected to establish a floor for market expectations, potentially ending a protracted period of downgrades. This reset could catalyze a rotation into undervalued, high-quality cyclical stocks, including autos and machinery, which UBS believes offer a more favorable risk-reward profile for medium-term returns. Potential downside for the broader market may be partially mitigated by supportive factors like resilient U.S. markets and ongoing corporate share buybacks in Japan.

Key Decisions for Investors

• Consider reducing exposure to overextended, momentum-driven sectors like tech services and utilities, as their valuations are stretched and they are vulnerable to a market reversal.
• Closely monitor the upcoming June-quarter earnings season for downward guidance revisions, as this could signal a bottoming of expectations and create a tactical entry point for a market rotation.
• Investors should begin identifying undervalued, high-quality cyclical stocks in sectors such as autos and machinery, which may offer superior medium-term returns post-earnings season.
• Maintain overall caution on Japanese equities until corporate guidance is reset, but recognize that corporate buybacks and US market strength may provide a floor, limiting severe downside.