Morgan Stanley ‘double upgrades’ Japan equities

Kiyoshi Ota | Bloomberg | Getty Images

Morgan Stanley took Japan equities to overweight from underweight, making it the top regional pick globally, replacing the U.S.

"Global reflation and U.S. dollar strength favors Japan equities," it said in a note dated Sunday.

The bank raised its target for the Topix index to 1800 for December 2017, from its previous forecast of 1190. On Monday, the Topix index closed at 1469.58.

The move by Morgan Stanley followed raising its 2017 earnings per share (EPS) forecast for the index to 108 yen from 83 yen.

That was in part because of expectations for the dollar/yen to trade at 125 by December 2017, compared with 107 previously, and 130 by mid-2018. Early Tuesday, the dollar was fetching 111.84 yen.

"Topix earnings are positively geared to a weakening of the yen," it said, noting that around 40 percent of Topix-company revenues come from non-domestic sources.

While strength in the dollar, which has surged since the U.S. presidential election's surprise outcome, was a negative for emerging markets, it would tend to help bolster Japan, the bank noted.

"We think there is early evidence that flows are starting to shift back into Japan and away from emerging markets in the two weeks since the U.S. presidential election," Morgan Stanley said, noting that the "starting point" was from an around 150 basis-point underweight position on Japan and rising positions in emerging markets.

It noted that among global equity funds tracked by EPFR, Japan had $8 billion of inflows in November-to-date, while $7 billion flowed out of emerging markets.

At the same time that Morgan Stanley expected more foreigners would buy back into Japan equities, it noted that the Bank of Japan was likely to continue its 6 trillion yen ($53.6 billion) in annual purchases of exchange-traded funds (ETFs) under its quantitative easing program. It also expected that Japan's Government Pension Investment Fund (GPIF), the world's largest public pension fund, could buy another $29 billion worth of Japanese equities to reach its target neutral domestic equity weight of 25 percent.

When it comes to sectors, Morgan Stanley "would strongly favor" exporters over domestic plays on the expectation of a weaker yen. It particularly preferred consumer discretionary and IT sectors, which tend to have the highest sensitivity to the yen weakening.

Insurance plays were also seen benefiting from a steeper yield curve, which was likely as the U.S. Federal Reserve appeared set to begin a tightening cycle next month. Among broader themes, Morgan Stanley advocated corporate restructuring, shareholder rewards and corporate governance improvement. It advised avoiding companies with production or parts of a supply chain in Mexico which then sells products to the U.S. market.

At the same time, Morgan Stanley cut emerging market equities to underweight, as the stronger dollar would hit the segment on translation effects and higher dollar debt servicing costs. It cited uncertainties over trade protectionism, supply chains and security arrangements due to the U.S. administration change.

Morgan Stanley wasn't alone in its newfound liking for Japanese equities.

JPMorgan Cazenove said in a note on Monday that the stronger U.S. dollar will help Japanese earnings, which had been downgraded "significantly" over the past year as the yen strengthened. It expected IT, energy and discretionary sectors to benefit most from a weaker yen, with healthcare, telecoms and utilities the relative losers.

But the stronger dollar was a headwind for U.S. stocks as around 32 percent of the S&P 500's topline earnings were from abroad, it noted, adding that it worried that further dollar strength would continue to hurt emerging market stocks.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

Follow CNBC International on Twitter and Facebook.