Strategy Question: Can Japan continue rallying?
Japan’s impressive equity market rally this year has caught markets by surprise. Positive headlines and the participation of big-name investors have boosted equities to levels unseen since the heyday of the 1980s “bubble economy”. Meanwhile, the yen has collapsed to its weakest in decades as the Bank of Japan (BoJ) remains one of the only major central banks to maintain ultra-easy monetary policy, even in the face of coordinated global tightening and rising inflation pressures. As the post-pandemic recovery continues, inflation could stay elevated and augment long-held behaviors and mindsets about inflation within Japan. Tourism remains a source of near-term consumption upside. Even as expectations for a shift from the BoJ have fallen, we continue to see some strength for the currency based on potentially lower U.S. Treasury yields. In equities, we caution against chasing the rally at the index level and would instead focus on actively selecting specific names that can benefit from cyclical and structural themes.
Taking stock of Japan’s recovery
Japan has been enjoying a relatively strong cyclical recovery since the post-pandemic re-opening. While there were no strictly-enforced “lockdowns”, sentiment and growth were severely depressed and only started to show sustainable strength as the effects of the pandemic faded. Recent corporate sentiment as indicated by PMI data has been relatively strong, especially for services.
The ongoing post-Covid consumption rebound has been helped by both domestic consumers and tourists, and the overall rise in asset prices has helped consumer sentiment. Japan’s Covid-19 fiscal stimulus was significant, and this rapid recovery is a similar profile to what we saw in the rest of the developed world post-reopening. A sustained improvement in inflation is also helping to shake a decades-long deflation mindset in Japan, which bodes well for capex and consumption.
This shift in the inflation mindset is indicated clearly by wage growth. Every spring, Japan’s Trade Union Confederation, known as Rengo, conducts negotiations with employers to raise wages. This year they managed to achieve a 3.8% raise, the most since 1993 and noticeably higher than the 2% or lower range seen in the past 20 years, when real wages have remained effectively stagnant. Prime Minister Kishida has also positioned higher wages at the center of his New Capitalism policy concept, which aims to expand income distribution. It is thus possible that more corporates could be pushed to implement these increases, as some major companies have already done.
This shift is both a cause and result of the broader cycle of higher inflation that we are seeing in the economy, where, by all measures, core inflation has significantly exceeded the BoJ’s 2% target, to now reach the highest levels in over 30 years (and it continues to accelerate).
The interesting point about this inflation cycle is that it is also becoming more broad-based rather than just being concentrated in a few items. The inflation diffusion index, which is the share of items in the CPI basket where prices have increased from a year ago minus those where prices have decreased, has surged, indicating that a large and growing proportion of items are seeing prices increase.
This index is pivotal to sustained inflation, and has also had an impact on inflation expectations. A vast majority of households are expecting over 5% inflation in the year ahead, which has been unheard of in Japan for decades. Strong inflation could be causing a level-set change or de-anchoring of inflation expectations, and this could fundamentally alter the wage growth and consumption backdrop in Japan.
Still some upside potential from tourism
Even as international tourism has rebounded in Japan, there is still upside potential for visitor numbers. Arrivals from most of the world have recovered to pre-Covid levels, but arrivals from China remain a tiny fraction of what they were, mainly due to ongoing passport renewals, visa difficulties and a lack of international flights to and from China. Prior to the pandemic, China contributed nearly a third of all tourist arrivals to Japan, and an incremental recovery there would still boost tourism from current levels as international flight capacity ramps up in the coming quarters. As such, an alternative way to gain exposure to China’s reopening without buying Chinese assets is through Japanese beneficiaries of tourism.
Near-term external uncertainties
The macro picture remains resilient and sentiment could stay constructive for a while, but the external sector remains a key driver for Japanese corporations and the economy, and uncertainties there could introduce headwinds to the macro and market outlook. On the one hand, import prices have skyrocketed. Given that Japan imports plenty of its economic inputs, high imported inflation (not helped by the weak yen) means corporate margins depend meaningfully on whether businesses can pass on increased costs to customers. On the other hand, on the export front companies could start to face some drags, especially if global growth slows cyclically from here, which remains our base case. In recent months, industrial production has stalled and inventories have started to climb. Manufacturing PMI data has also disappointed. This stands in some contrast to the upside surprises in export production for other North Asian economies such as South Korea and Taiwan, given the different export product mix for Japan – particularly the smaller focus on semiconductors. As such, this year-to-date equity rally, mostly led by cyclically-geared exporters that dominate the index, could start to face headwinds.
Long-term structural issues
Looking beyond this cycle, many of Japan’s longer-term structural problems remain, and these are unlikely to change. Demographics are likely to continue worsening as the population ages, and Japan is long past its bottom in the dependency ratio. An expanding economically-dependent population coupled with a shrinking economically-productive population makes for an uninspiring long-term growth outlook. As a result, potential growth has structurally fallen, a natural process given a falling working-age population and low productivity, while structurally high debt levels also don’t help the case. The impact of ambitious policy directions from the current administration also remain to be seen.
Dialing back our yen expectations
As discussed in our analysis on the BoJ in an earlier report, the yen is relatively easy to model. The 10-year U.S. Treasury (UST) – Japan Government Bond (JGB) rate differential explained over 90% of the movements in USDJPY over the past two years. At the beginning of this year, we had expected a squeeze in rate differentials from both sides. We expected inflation to broaden out and stay above the BoJ target as wage growth picks up. We also expected more pragmatic BoJ policies as former Governor Kuroda’s tenure came to an end.
So far, expectations for inflation have largely played out. Having said that, Governor Ueda has demonstrated exceptional patience on this front. So far we have not received any clear signal from his communications regarding a scaling back of these unprecedented easing measures. As inflation continues to shoot up, real rates are becoming deeply negative, effectively equivalent to even more monetary easing. From here, we think the case for maintaining the massive easing stance is becoming weaker, but from an investment positioning perspective – the risk-reward of speculating a BoJ policy shift may not be particularly attractive.
In addition, over the past two months, 10-year JGB yields have fallen and the current cap of the Yield Curve Control (YCC) framework has become less of a disruptor to markets, which could reduce the urgency for another YCC adjustment. Markets also seem to be pricing out expectations for a BoJ pivot, and the 10-year U.S. Treasury has effectively become the only major driver of USDJPY.
While we still think the yen could strengthen from here, without help from the BoJ the move would be only driven by lower USD yields, implying a smaller upside potential. Our current outlook for 10-year UST yields implies USDJPY at 135 and 130 for year-end and mid-2024 respectively.
Selective in equities
With a higher USDJPY outlook, we have also raised our Topix outlook to 2,080-2,120 for year-end and 2,130-2,170 for mid-2024. Even after these positive revisions, Japanese equity markets remain fully valued and we are firmly neutral at the broad market level at this juncture. We make the following observations: 1) With the weekly RSI (Relative Strength Index) above 70, the Topix is overbought and vulnerable to a pullback; 2) Valuations at 14.6x forward P/E are now in-line with the historical average and are no longer inexpensive; 3) Some of the top performing segments of the market have been the most economically sensitive exporters, which are now trading at elevated levels compared to global peers and proxies. With our base case view for a U.S. recession, or at least an economic slowdown, these export-driven earnings are at risk and recent weakness in manufacturing PMIs should be watched closely, and 4) Our USDJPY outlook is meaningfully lower than current levels (by around 10%) and would have negative implications for Japanese export-oriented earnings. That said, we continue to find individual alpha opportunities in the Japanese equity market that have meaningfully lagged the market across a number of sub-sectors linked to the domestic economic recovery and even select names in the semiconductor industry. With volatility elevated, equity structures with upside participation and meaningful downside protection are a preferred approach for clients who would like to increase their allocation in Japanese equities.
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The TOPIX, also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange. The index is supplemented by the subindices of the 33 industry sectors. The index calculation excludes temporary issues and preferred stocks, and has a base value of 100 as of January 4, 1968.
The relative strength index (RSI) is a technical indicator used in the analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period.