Insight

Japan market outlook

Japan market outlook

Japanese stocks have experienced investor momentum lately in what seems to be a perfect storm. While MSCI World has been flat over the past quarter, the Nikkei is up +14% in local currency terms, to levels not seen since the mid-1990s.1

Reasons behind the rally

From a global macro perspective, investors are sitting on excess piles of cash waiting to deploy to attractive value opportunities. The US economy is expected to make a bumpy landing in the 2H and the Fed has recently signaled that it may not be done with rate hikes this year. China’s reopening has recently hit a bit of turbulence and policymakers haven’t yet rolled out any additional stimulus. These competitive dynamics have allowed Japan’s cyclical advantage to shine.

Because Japan reopened from COVID much later than other developed economies, domestic spending is only at its nascent stage, while household spending in the US and other G10 economies is starting to slow. Personal consumption is accelerating in Japan due to government fiscal stimulus measures. This has led to inflation reaching decade highs after long struggling with deflation. More encouragingly, wages are also starting to rise materially. 

Nikkei 225 Index
Nikkei 225 Index

Source: Bloomberg. Data as of 2 June 2023. 

Corporate earnings and economic growth are expected to pick up due to a weaker yen

Over the next year, I expect Japanese corporate earnings to improve. Japan imports a significant portion of its energy needs and the fall in energy prices could help offset weaker exports. The JPY’s collapse against the USD early last year – which should translate into stronger Japanese corporate earnings, especially in Japanese MNCs companies with large overseas presences.

The JPY may appear significantly undervalued when compared to the USD though it is no longer overvalued against the RMB. Foreign equity investors can still benefit from the JPY’s continued weakness as corporate earnings are boosted by a weaker yen and price performance improves if the yen appreciates.  

Despite the demographic decline in Japan over the past few decades, the economy has been able to grow through efficiency and productivity gains coupled with overseas investment and trade. Longer term, a rising China, Indonesia, India and Vietnam present significant capital and infrastructure investment opportunities for Japanese corporates, already adept with trading and investing with these countries.

I can’t think of any other developed economy that has so many regional greenfield opportunities at its doorstep and Japanese corporates are likely to benefit over the coming years as EM Asia develops.

Exiting YCC could put pressure on equities

The leadership change at the BoJ back in April did not lead to an early change in Japan’s ultra-loose monetary policy - yield curve control (YCC) - as some had expected. Still, winds are changing: Japanese inflation has finally started to rise. Core CPI (which doesn’t include more volatile items such as good and energy) is now at a 30 year high. If inflation continues to grind higher, it’s likely that the BoJ will be forced to start unwinding its YCC, perhaps as soon as this Fall.

As Japanese equities near bull run territory, I think that the biggest risk could come from the BoJ abandoning YCC. A rising domestic rate environment could warrant Japanese corporations to repatriate their dividends and profits and drive the JPY and global bond yields higher. There could be headwinds for EM Asia assets as this suction sounds grows louder, with Japanese private and public funds pivoting their capital back to Japan.    

Still, a rise in the policy and discount rates could initially pressure equities and their valuations as bonds become more attractive. During the quarters following the Fed’s initial hike in March 2022, US stocks fell into bear market territory as the Fed raised interest rates by over 500bps in just 12 months. The BoJ is certainly not going to follow the Fed’s path towards restrictive territory because inflation has not risen to intolerable levels. Japanese monetary policy is normalizing from a decade of being ultra-loose and I think equities can still perform well during this transition though there could be some initial bumps.

Is Japan worth investing?

I think investors may want to be invested in Japan stocks over the longer period because of upcoming structural changes by the Tokyo Stock Exchange (TSE), which could boost company valuations and lead to another meaningful leg up to the market. A significant portion of the Japanese market is trading below book value and sustained valuation expansion could bring back both domestic and foreign investors.

That said, the TSE has made clear that the onus is still largely on corporates themselves to take charge in improving capital efficiency as well as investor dialogue. Still, the pronounced regulatory efforts aimed at raising shareholder value and improving capital allocation and efficiency should be cheered by the market. 

I think it’s possible that Japanese equities could outperform other DM this year. I am cautiously optimistic on Japanese equities: the asset class has seen many false dawns, but recent global macro and domestic demand dynamics have been a promising start. How the BoJ exits YCC remains a concern and there are likely no good answers.

References

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    Source: Bloomberg. Data as of 2 June 2023. 

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