Asia insights

Japan: starting to deliver

Our overweight to Japanese equities is our highest conviction investment view on a six- to 12-month horizon. We think clarity from the Bank of Japan (BOJ) last month that its interest rate hike was about normalizing policy - and not anxiety over inflation - diminishes tail risks and allows focus to return to a brightening fundamental backdrop. Focus reverts to micro developments such as earnings growth and shareholder-friendly corporate reforms that have fueled Japanese equities and remain key to sustaining the rally, in our view.

The Tokyo Stock Exchange (TSE) has spearheaded the charge to urge company managements to disclose plans that signal a commitment to better allocate capital and prioritize creating shareholder value.[1] In a landmark move, the TSE began disclosing a monthly list of companies that are planning to improve their capital management - a nudge to those that are trading below book value with no improvement plans. As of 15 March 2024, around half of Japanese corporates listed on the TSE Prime market comprising top-tier firms have either disclosed plans or declared that their plan to do so is under consideration. This list serves as a “positive” list, spotlighting companies in compliance or on the path to compliance, while subtly identifying those falling short.

Market response suggests investors are rewarding reform intent. Japan’s Topix is up more than 43% in yen terms since the start of 2023.[2] But under the surface, shares of companies that have disclosed plans to boost governance in line with Tokyo Stock Exchange guidelines have outperformed those that have not by more than sixteen percentage points over that period. See chart. Momentum behind corporate reforms is a key reason we went further overweight Japanese equities last month.

“Corporate reforms” cover a wide gamut of activities including but not limited to improving capital allocation to boost shareholder returns, bolstering governance and selling down cross-shareholdings. The “third arrow” of former Prime Minister’s Shinzo Abe’s ambitious reform agenda – dubbed Abenomics - more than a decade ago aimed at reforming Japan’s corporate sector. Yet after an initial burst of enthusiasm, progress slowed – as did investor interest. The impetus for a renewed push comes via a coordinated effort from the government ministries like the Ministry of Economy, Trade and Industry (METI), regulators like the Tokyo Stock Exchange (TSE) and industry lobbies like Keidanren (the Japan Business Federation).

The clearest evidence of changing corporate behavior has been the uptick in buybacks and dividends.[3] So far, companies have funded this return of capital to shareholders from cash reserves. Yet going forward, we think the focus will shift to initiatives – like capital spending – that companies undertake to boost growth. Japanese firms have made some progress on boosting lackluster return on equity or profitability. Return on equity is up from negative levels in 2010 to 9% on average in Japan, according to LSEG Datastream as of March 2024. That is still half of the U.S. metric, but we think reforms can help narrow the gap. We think the momentum behind corporate reforms will remain strong ahead of the annual general meeting season in June where companies will put forth proposals to shareholders.

The macro backdrop in Japan is conducive to taking risk, in our view. We think the BOJ will act cautiously and not sabotage the break from decades of deflation or low inflation. Sustainable, mild inflation is a positive for company revenues while healthy wage growth is likely to fuel consumption.

The narrative that the Japanese equity rally has been mostly about the weak yen – that is close to a 34-year low against the U.S. dollar[4] - is oversimplified, we think. A weak yen helps boost the value of corporate earnings made. Rising U.S. yields have piled more pressure on the weak yen, a concern for the BOJ and raising the risk of currency intervention. Yet we don’t see the BOJ aggressively tightening policy given how cautiously it ended negative policy rates. Importantly, our overweight to Japanese equities is rooted in a much more fundamental shift – the combination of a return to inflation, wage growth and a corporate governance revolution that markets are not fully pricing in – that overpowers any impact from currency moves.

[1] On March 31, 2023, Tokyo Stock Exchange (TSE) requested that all listed companies on the Prime and Standard Markets take "action to implement management that is conscious of cost of capital and stock price."

[2] Data from LSEG Datastream as of March 28, 2024

[3] Nikkei, January 2024: Japan firms’ share buybacks expanded to a record U.S.$65 bn in 2023.

[4] LSEG Datastream, April 1, 2024