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Japanese equities
Preference: neutral

UBS View
Topix (27 June): 745 (last month: 721)
Topix (6-month target): 780
• We expect earnings growth of about 45% over the coming 12 months. This exceptional high growth is mainly due to the two natural disasters last year, as well as tax regulation changes which caused a number of one-time losses to be booked in the fiscal year that ended in March 2012.
• In our base case scenario, we see only limited scope for an additional earnings boost from the local economic recovery, given the slowing in export markets. Japanese companies are expected to continue their cost reduction efforts to counter the impact of a strong yen.
• The Japanese government has started implementing its JPY 18tn recovery budget in 4Q 2011, and we expect the budget to boost Japanese GDP by 1–1.5% in FY2012.
• Mainly due to the earnings rebound, we expect the TOPIX trailing P/E to drop from around 16.5x to 14x – 14.5x by year end; still the earnings rebound should provide some room for moderate price increases.

Recommendations
Tactical (6 months)
• The earthquake in Japan and recent floods in Thailand have impacted Japanese earnings negatively. A recovery from these disasters should benefit auto and industrial stocks in particular.
• We prefer companies that continue cost reduction initiatives to maintain price competitiveness during the period of yen strength.

Strategic (1 to 2 years)
• A weaker USDJPY may drive Japanese companies’ earnings recovery beyond a technical recovery from natural disasters.
• A rapidly aging population and the lack of a powerful and stable government remain negative for the country’s longer-term economic prospects.

Positive scenario
Topix (6-month target): 900
• Stronger global demand and stabilizing European markets provide an additional boost to earnings, and also lead to improved risk taking. Falling risk aversion is likely to lead to a weaker yen, providing further upside to earnings. TOPIX target is based on 16.0x trailing P/E.

Negative scenario
Topix (6-month target): 600
• Faltering global growth leads to weak exports, triggering negative earnings surprises. A strengthening USDJPY below 75 in response to rising risk aversion might provide an additional drag on the economy and earnings. We would then expect the P/E ratio to contract to 13.5x, even if earnings show no recovery.
Note: Scenarios refer to global economic scenarios (see slide 7)

Japanese realized earnings likely to recover going forward
[Chart showing earnings trend from 1988 to 2012]
Source: Thomson Reuters, UBS CIO, as of 21 June 2012
Note: Past performance is not an indication of future returns.

What we're watching Why it matters
JPY and exports
The exchange rate is an important factor for the Japanese equity market, and central bank intervention is a key swing factor. Japan’s trade balance could be in deficit and may impact USDJPY rates. Key date: 09 July, Japanese trade balance

BoJ’s monetary policy board meeting
The Bank of Japan’s (BoJ) additional commitment to its asset purchase program, which is currently JPY 65tn in size, would lead to a weaker yen, in our view. Key date: 12 July, BoJ policy meeting

UBS
For further information please contact CIO asset class specialist Toru Ibayashi, toru.ibayashi@ubs.com
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Please see important disclaimer and disclosures at the end of the document.
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