Morgan Stanley has upgraded its view on Japanese stocks, citing a bullish economy and improving equity returns, placing it above the U.S. as its top equity market pick.
In a report published Sunday, which lifted it ratings on Japanese equities by two notches to Overweight from Underweight, the bank said it expects Japanese corporate ROE to reach a new 12-year high of 9.2% in 2018 as the yen continues to depreciate against the dollar. The bank also cited a stronger-than-expected GDP growth in Japan and a stronger global expansion.
"Japan is now our top pick in global equity regions, replacing the US. We recommend that the US-dollar-based investor in Japan equities hedge the yen for 2017," the bank said in its November 27 report.
Morgan Stanley estimates the yen will depreciate to ¥130 against the dollar by mid-2018, compared with a recent level of around ¥112. It also expects Topix to reach 1,800 by the end of 2017, up from the Monday close of 1,469.
The index, the broadest measure of Japanese stocks, has been climbing since the summer and is now nearing its highest level this year, which it started at 1,547.30.
Following the rally, the bank expects Topix to rally to a consensus forward P/E of 15.0X, up from the current 14.3X. In June 2015, Japanese equities traded peaked at 15.4X as the yen traded at ¥125 against the dollar.
The bank expects the rally to be supported first by foreign investors, who will likely return to Japanese equities once companies enjoy V-shaped recovery in earnings, and second the Bank of Japan, which will likely continue its ¥6 trillion ($53 billion) annual purchase of equity index ETFs.