One market on the cusp of a new dawn: Japan

Optimistic investors have pushed developed market equities to the top of their calendar year range.

However, it’s important to note that uncertainty still surrounds two of the key issues that have hung over the market since last year: inflation and interest rates.

Although, in most developed markets, headline inflation has come down, core inflation – which excludes food and energy – has moderated a lot less. On top of this, investors have been excited at the prospect that developed market central banks may now be approaching the end of their rate hiking cycles, thanks to the scale of the tightening they’ve already done and the lagged impact of recent U.S. regional bank stress.

Given that core inflation remains sticky and recent job numbers revealed the lowest U.S. unemployment rate since 1968, we see the market’s focus returning to the challenging macro outlook after a U.S. debt ceiling deal. Indeed, markets have recently priced back in further Fed rate hikes in July. All this means that the recent rally in the U.S. could be close to running out of steam.

For those looking for a simpler story, one market that truly looks to be on the cusp of a new dawn is Japan.

The Nikkei is up close to 20% in local currency terms – hitting a thirty-three year high. In contrast to its developed market peers, Japanese equities stand to benefit from three key positive economic, structural, and technical factors.

Read on to find out why Japanese equities currently offer both tactical upside and the potential for a long-term strategic allocation.

Japan inflation may drive savers back to stocks

Firstly, the growth momentum in the Japanese economy contrasts with the risk of further slowdowns in the U.S. and Europe.

Whereas these markets are struggling to come to terms with below-trend growth, tighter credit conditions and higher for longer interest rates, Japanese economic growth is expected to remain positive into next year. This is most clearly shown by the output gap: the economic measure of the difference between the actual output of an economy and its potential output. Whereas the U.S. and Euro area economies are operating beyond their full capacity, Japan has yet to swing into positive territory.

This looks set to happen over the next several quarters. For instance, Japan’s tourism sector has rebounded post the pandemic and Japan’s Service Sector PMIs have been strengthening. With visitor numbers still below 2019 averages, this re-opening still has further room to run.

On top of this growth momentum, Japan finally looks to be awaking from its deflationary stupor. Inflation (ex food and energy) has been accelerating year-on-year. Nominal retail sales in the first quarter of 2023 were 7% higher than the year previously*, partly due to higher prices, but also a reflection of the rebound in consumer confidence since the start of the year. A tight labour market and higher costs of living mean that employers have shown a greater willingness to raise wages than they have in the past. This should further boost personal consumption, which makes up the largest portion of GDP.

With inflation in Japan starting to take root, investors are also awake to the possibility that this may persuade the Bank of Japan (BoJ) to finally consider changing its ultra-loose momentary policy in the months ahead. This would be a sea change for individual investors in Japan. While cash may have been king when there was deflation, inflation may drive savers back to the stock market. Japanese household assets currently only have a 10% allocation to equities (versus 20% in Europe, and almost 40% in the U.S.). Exchange Traded Funds (ETFs) stand to benefit as these could prove an initial way back into equities for many.

Japan equity rerating reveals renewed interest

The cumulative impact of Abenomics – a series of economic reforms launched over ten years ago – is becoming increasingly apparent. Monetary easing and fiscal consolidation have laid the groundwork and the private sector has now taken the reins. Japanese companies are making better use of their abundant cash and companies have responded to recent changes in corporate governance, improving company board composition, communication with shareholders and outside activist investors.

Last year saw Japanese companies deliver record amounts of share buybacks. Corporate balance sheets in Japan are in much better shape than in previous years and, for the market overall, the ROE for listed equities has more than doubled in the last ten years. We expect corporate Japan to keep unlocking value as management teams pay more attention to the costs of capital, corporate governance, and institutional investor stewardship. 

Japan boasts an array of world class firms, with leaders in semiconductor equipment, healthcare, medtech and robotics as well as traditional heavy industries and speciality chemical firms. Warren Buffet’s recent investments in Japan, reported in early April, have added to recent optimism and it’s significant that he has taken stakes in the likes of Itochu Corp, Mitsubishi Corp, and Sumitomo Corp – all IJP AU holdings. Many of these firms sell products far beyond Japan and for investors concerned about growing U.S. – China political tension, Japan may be seen as a preferable way to tap into Asia’s economic recovery.

All that said, and despite robust performance in recent months, valuations are low. The price-to-earnings ratio of the MSCI Japan (which IJP AU tracks) at 14.2 times, which remains below its 15-year average and represents a steep discount with the U.S. In recognition of the importance of improving the valuation of Japanese listed companies, the Tokyo Stock Exchange recently revamped Japan’s market structure, grouping companies into ‘prime’, ‘standard’ and ‘growth’ segments in order to spur a further rerating of Japanese equities. With half of all Japanese companies still trading on a price-to-book ratio below one, there is plenty of room for improvement. As corporate returns continue to improve, we expect share prices to follow.

  Foreign investors underweight Japanese stocks

Investment returns are a function of price and positioning. In Japan, equity valuations are low, and positioning remains light. Foreign investors have been underweight Japanese equities for the past five years and the latest Bank of America Fund Managers Survey revealed that, despite the pickup in performance, this remains the case for most active managers.

However, this could be changing. In the ETP space, we’ve seen a pickup in foreign investor interest, with USD $1.4B added in April ($443M into US-listed funds, $985M into EMEA-listed funds) and buying continuing in last month, the highest single month of inflows since 2020 ($645M into US-listed funds, $469M into EMEA-listed funds).

With Japan out of favour in recent years, there are more marginal buyers when it comes to foreign investors. This contrasts with the U.S. market, on which global investors have relied heavily to power equity returns. With Tech – another crowded trade – driving the bulk of U.S. returns so far this year, investors may want to diversify. As corporate profitability continues to improve and the macro regime in Japan shifts from deflation to inflation, we expect an increasing number of foreign investors to address their underweight to Japanese equities.

For Australian investors, currency could prove another reason to invest in Japan. The Japanese Yen is widely considered to be undervalued and the prospect of tighter monetary policy from the BoJ means that we could see the Japanese yen strengthen against the Aussie dollar (AUD) and potentially add to the returns of AUD-based investors.