UBS Cuts Japanese Stocks to Sell, Favors Europe and UK via Investing.com

Investing.com — UBS recently took a step down by downgrading Japanese stocks to a “sell” rating, signaling a shift in investment strategy towards Europe and the UK.

Despite structural improvements in Japan, UBS analysts believe several cyclical challenges make Japanese stocks less attractive compared to their European and British counterparts.

UBS’s decision to downgrade Japanese stocks reflects a confluence of factors that pose significant risks to the Japanese market, making it less attractive in the current global economic environment.

Japan’s economy is characterized by high operating leverage, which means that its corporate earnings are particularly sensitive to changes in global economic conditions.

As global purchasing managers’ indices (PMIs) begin to peak, signaling a potential slowdown in manufacturing output, Japan’s high leverage makes its markets more vulnerable to underperformance during a recession.

This heightened sensitivity is particularly worrying given the global economic landscape, where growth momentum appears to be waning.

Adding to these concerns is Japan’s substantial exposure to China. Japan’s exports to China represent 2.9% of its GDP, significantly higher than Europe’s exposure.

With China’s economy currently facing a number of challenges, including the risk of deflation and slow growth, Japan’s heavy reliance on Chinese demand poses a serious risk to its economic stability.

Any further deterioration in economic conditions in China could have enormous negative effects on Japan’s GDP and corporate earnings.

Additionally, the anticipated trajectory of Treasury Inflation-Protected Securities (TIPS) yields is another factor weighing on Japan’s outlook. “For the end of 2025, UBS forecasts 1.4% 10-year TIPS (I agree), and Japan is the worst-performing region when TIPS yields fall,” the analysts said.

This relationship underscores the vulnerability of Japan’s market in a global environment where inflation-adjusted yields are on a downward trend.

Currency dynamics and interest rate expectations further compound these challenges. UBS forecasts that the Bank of Japan (BoJ) will raise interest rates to 1% by mid-2025, which is above current market expectations. A rate hike of this magnitude is likely to strengthen the yen, which in turn would hurt Japanese exporters by making their products more expensive on global markets.

Historically, a 10% appreciation of the yen has been associated with a similar level of underperformance of Japanese stocks relative to global markets.

In addition to these cyclical headwinds, Japan’s corporate governance, while improving, still lags behind that of Europe and the UK.

Japanese companies do not cancel share buybacks at the same rate as their European counterparts, which could dilute equity and reduce shareholder value over time.

Furthermore, while Japanese stocks might appear cheap on the surface, this valuation advantage is deceptive.

Much of the perceived value comes from inward-looking stocks, which are undervalued, while growth-oriented stocks – favored by foreign investors – are not as attractively priced compared to their global peers.

In contrast to the challenges facing Japan, UBS identifies several compelling reasons to favor European and UK stocks. Lower operating leverage in these regions makes their markets less vulnerable to global economic slowdowns, providing a more stable investment environment.

Unlike Japan, Europe and the UK have less economic exposure to China, which reduces the risks associated with continued challenges in the Chinese economy.

Monetary policy also plays a key role in UBS’s preference for Europe and the UK. UBS expects interest rates in these regions to be cut by the end of 2025, which is expected to boost GDP growth by 1%.

This is in stark contrast to Japan, where rising interest rates could stifle economic growth and corporate profitability.

Moreover, European stocks posted better earnings revisions versus Japan, pointing to stronger economic fundamentals and corporate performance.

Investors in European stocks also benefit from higher redemption yields and total returns (including dividends) than those available in Japan.

In addition, European stocks are trading at more favorable price-to-earnings ratios, further enhancing their appeal.

The outlook for currency movements also favors Europe and the UK. UBS forecasts that the yen will appreciate against the euro by 10% by the end of 2025.

This expected currency shift is likely to erode the competitiveness of Japanese exporters, particularly in key sectors such as automobiles and capital goods, where they compete directly with European firms.