The outlook for Japanese equity market following the recent rally

Much attention has been given to the US bull market run over the past 12 months, as MSCI US rose by 21.1% compared to MSCI Japan, up only 16.7% in USD terms.1
Still, the US rally has been very narrow, driven by the “magnificent seven” stocks - the median constituent of MSCI US was up only 8% in the past 12 months whereas in Japan, the median constituent was up 35% in USD terms.1
The Japanese rally last year attracted only modest foreign investor interest – around USD 40bn of new money flowed into Japanese equities, compared to back during the Abenomics heyday of 2013, when USD 160bn of foreign funds washed up in Japanese stocks.
But all that has started to change starting this year.
The bull rally in Japan’s equity market so far this year, with the Nikkei225 soaring to levels not seen since 1989, has largely been driven by foreign fund flows.
Foreign investors have snapped up Japanese stocks to the tune of 2.8 trillion yen on a net basis.2
This time around, foreign capital has piled into Japan’s largest stocks such as automaker and electronics companies.
In fact, TOPIX Core 30 Index, which consists of the largest and most liquid stocks listed in the Tokyo Stock Exchange, has outperformed Nikkei 225, TOPIX or other major indices.
Source: Macrobond. Data as of 15 Febraury 2024.
Foreign investors to continue buying Japanese equities
We expect foreign investors – largely uninterested in Japan equities in past decades – to continue buying these large-cap stocks after missing out on last year’s bull run.
Even though expectations are for a continued appreciation in large-cap Japanese equities in the near-term, foreign investors are likely to diversify their Japan equity holdings over the coming quarters as the market rally likely broadens its focus.
Unexpected technical recession not a major concern
Questions have arisen on whether the recent stock market outperformance can hold up, in light of the unexpected technical recession last quarter.
The Q4’23 GDP growth fell -0.4% on a sequential basis (versus median estimates of +1.1%) after a -3.3% q/q fall in Q3.3 The GDP miss last quarter was driven by a weaker consumption and government spending.
True, the Japanese economy could be experiencing a temporary soft patch – domestic demand has been trending downwards though countered somewhat by more resilient exports of services and tourism.
Private consumption in the near-term is likely to remain tepid and growth in Q1 could underwhelm as the consumption recovery is delayed until after the Spring-time wage negotiations.
The weaker than expected Japanese data coupled with a hotter CPI print in the US, has led to another round of JPY depreciation.
Still, I’m not all that worried about this current soft patch in the Japanese economy.
Part of the technical recession can be attributed to excess supply and inventory in the system, and the weaker than expected GDP print could prolong the BOJ’s ultra-loose monetary policies.
I believe that consumption is likely to pick up soon driven by faster nominal wage growth and slowing CPI inflation.
If the economy reaccelerates coupled with a stronger Shunto wage negotiation that begins in the spring time, this could mean that the BOJ continues with its monetary policy normalization, with a possible rate hike in April.
I believe that investors are willing to see through the temporary dip in economic performance because this time around, there are broader structural forces at play.
A real turn-around in the Japanese equity market
I believe that foreign investors are starting to see that the time has come for a real turn-around in the Japanese equity market.
Despite the recent technical recession in H2 of last year, growth in 2023 was very impressive.
Elevated inflation, not seen for decades, propelled Japanese GDP growth to 5.7% y/y in 2023, the highest since 1991 of 6.5%. Core CPI has been topping up above 2% for the past 1.5 years.
For corporate Japan, this has meant stronger pricing power – which has led to robust earnings growth driven by margin expansion.
Japanese corporations have experienced strong revenue growth and expanding operating profits, leading to record levels of cash deposits.
Outlook - Structural forces to drive outperformance
There are other structural forces at play that could lead to Japanese market outperformance over the coming years.
Firstly, the Tokyo Stock Exchange has announced a raft of measures to improve shareholder returns which could further drive foreign investor interest into sleepy Japanese corporates.
These measures have already resulted in Japanese companies purchasing record share buybacks last year of around USD 1.8trn4 and issued record annual dividends5.
Secondly, there are positive changes to tax-free savings accounts – designed by policymakers to nudge households cash holdings into riskier assets - which may see around USD 189bn in household cash migrate into equity products over the coming years.6
Domestic Japanese buying could offset the recent momentum buying by Chinese investors7 if there is a U-turn driven by recent measures undertaken by Beijing to give Chinese markets a boost.8
Risk factors to watch out for
Still, I believe that there are two main risks to Japanese markets that investors should keep in mind.
Firstly, there are domestic political risks to be aware of. Investors may not be fully discounting the political uncertainties facing the ruling LDP party.
There appears to be a small scandal that’s brewing that could impact local elections9, due by September. It’s worth keeping an eye on the ever-evolving political situation in Japan and whether this could impair market sentiment.
Secondly, if the BOJ raises rates starting in April and the Fed starts to cut rates in Q2, this could lead to a strong appreciation in the JPY driven by interest rate differentials.
It’s likely that Japan’s negative rate, ultra-loose monetary policy path is coming to an end.
There has historically been a perception among foreign investors about a causal relationship between the JPY and Japanese equities: that a weak JPY is good for Japanese stocks because it boosts Japanese exporter earnings.
While that may hold some truth, it’s important to remember that the JPY has been structurally undervalued for so long and any appreciation over the coming year is likely to be gradual with very little impact on the Japanese economy nor corporate earnings.
It’s clear that the BOJ is likely to move very deliberately and slowly towards its normalizing path.
Investors are piling in to the Japanese market for the positive structural changes
I don’t believe that Japanese corporate competitiveness is going to be undermined by the BOJ nor that an appreciating JPY later this year will upset the equity market run.
It’s clear that investors are piling in to the Japanese market for the positive structural changes and not because the JPY is relatively weak.
With contribution from Tomo Kinoshita, Thomas Wu
Reference:
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1
Source: Bloomberg, as of 15 February, 2024
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2
Source: Ministry of Finance, net basis this year until 3 February.
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3
Source: Reuters, as of 15 February, 2024
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4
Source: Japan firms' share buybacks to reach record level in 2023: survey (kyodonews.net)
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5
Source: Japan Inc. annual dividends at record levels again - Nikkei Asia
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6
Source: What is Japan's NISA tax-free investment scheme? | Reuters
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7
Source: Chinese Traders Ignore Warning in Chase for Japanese Stocks - Bloomberg
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8
Source: China Weighs Stock Market Rescue Package Backed by $278 Billion - Bloomberg
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9
Source: Mired in scandal, the LDP chips away at its factions - The Japan Times