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Investment Strategy

Japan: capitalizing on the pullback

Apr 25, 2024

Authors: Julia Wang, Cameron Chui, Yuxuan Tang, Weiheng Chen
 

After a stellar first quarter for global markets, investor sentiment turned more cautious in April. Over the last few weeks, markets have been digesting macro risks emanating from inflation surprises in the U.S. and continued geopolitical uncertainty. 

After a meaningful rally earlier in the year, these risks have sparked a sell-off in global equity markets in recent weeks. At the time of writing, the TOPIX index has pulled back 5.3%, after reaching a 35-year high in late March. 

We believe the recent pullback creates an even more compelling buying opportunity for investors seeking to participate in the regime shifts occurring in Japan. Sectors that stand out to us include financials, consumer discretionary (excluding autos), technology, industrials and real estate. Meanwhile, the Japanese yen (JPY) has weakened to a fresh cycle low of over JPY155 to the dollar on the back of a resurgent USD. We believe the JPY may remain weak for some time yet, and we advocate for USD-based investors to hedge potential JPY weakness or borrow yen to fund an equity position. 

In our update two months ago we wrote about Japan’s emergence from three decades of deflation, and the generational opportunity this brings to Japanese assets. To recap, Japan’s economy and markets stand to benefit from a constructive mix of global and domestic tailwinds:

  • Inflation has returned and the economy is normalizing, which is boosting confidence as the long-held deflation psyche finally breaks.
  • Globally, the shifts in supply chains coupled with technological trends in semiconductors benefits Japan’s economically important manufacturing sector.
  • The backdrop of higher U.S. interest rates and a persistently stronger USD keeps the JPY at a weaker level, helping to further increase the competitiveness of its exporters.
  • Fiscally, the government is implementing industrial policy aimed at luring global companies towards investment in Japan’s manufacturing capacity.
  • Last but not least, the Bank of Japan (BoJ) is still keeping monetary policy accommodative to support capex and corporate borrowing needs.

These factors continue to underpin our positive thesis on Japan, and recent data has affirmed our view. 

In recent months, corporate investment continues to be an important driver of economic growth. Capex growth remains strong across software, R&D and even land purchases (which have been contracting for two decades). In Q4 2023, investment grew 8% in real terms. 

CAPEX GROWTH REMAINS STRONG ACROSS SOFTWARE, R&D AND LAND PURCHASES

Corporate investment across sectors, YoY % 4 quarters moving average

Source: Bank of Japan, Haver Analytics. Data as of March 31, 2024
The corporate outlook remains positive. Corporate surveys suggest executives plan to keep investing – and the recovery in loan demand is evidence of it. After decades of underinvestment, the catch-up in capex could continue to drive growth on a multi-year basis. This is especially timely as Japan is seeking to capitalize on shifting global supply chains and technological trends as a potential beneficiary of heightening global trade tensions, particularly between the U.S. and China. Japan’s government – along with local corporate sectors – are spending billions to reinvigorate the semiconductor business, building on the country’s strength in equipment and materials. Over time, these investments can help to support a recovery in productivity growth, which has languished for years. 

JAPAN’S AGGREGATE DEMAND IS RISING, AS SEEN IN THE RISE IN LOANS RELATIVE TO GDP

Japan bank loans as a percentage of GDP, %

Source: Bank of Japan, Cabinet Office of Japan, JPMAM. Data as of Q4 2023.
Meanwhile, the domestic consumption recovery has disappointed, as households are still reeling from the squeeze on real wages in 2023 as inflation spiked to multi-decade highs. That said, consumer confidence has recovered to a post-pandemic high, and will likely continue to improve on the back of a positive wealth effect due to rising asset prices and the prospects of higher wage growth, which has finally started to take hold across the economy. 

NOMINAL CONSUMPTION ADJUSTED FOR TOURISM IS GROWING, WITH INCREMENTAL IMPROVEMENT IN REAL CONSUMPTION

Consumption Index, indexed 2015 = 100

Source: Bank of Japan, Haver Analytics. Data as of February 29, 2024

We believe the BoJ will likely be able to manage those risks and maintain accommodative policy to support continued reflation. In the upcoming BoJ meeting on 26th April, the central bank will likely lower its GDP growth forecast for 2024 slightly, acknowledging the uncertainty in the global economy. Reports suggest that inflation forecasts could also be upgraded slightly – a nod to growing confidence in the reflation path.

However, market volatility, particularly in the currency, has come under the spotlight in recent weeks and is on the central bank’s watchlist. Sharp yen weakness has led some to call for a more forceful monetary policy response from the BoJ, as rates remain deeply accommodative. However, we are skeptical that a sharper tightening is appropriate, and any incremental moves from the BoJ are unlikely to change the fact that Japan has one of the lowest nominal and real rates amongst major economies. On the other hand, premature tightening, if not warranted by economic fundamentals, could risk undermining the nascent growth recovery and reflation progress. Balancing these risks, the BoJ will likely try to keep policy accommodative as it monitors two-sided inflation risks in the near-term. 

JAPAN’S REAL RATES ARE STILL SOME OF THE LOWEST AMONGST MAJOR ECONOMIES

Real 10-year JGB yield and policy rate, %

Source: Bloomberg Finance L.P.. Data as of March 29, 2024

With a still-supportive macro and policy backdrop, we see now as an opportune time to add to Japanese equities, particularly for the majority of investors who remain under-allocated to Japan relative to global benchmarks.

We expect low-to-mid teens upside and maintain our Topix outlook of 2,900-3,000 by end-2024. Domestic reflation and the weaker yen are expected to drive nominal growth rates higher and we expect 11-13% earnings growth in 2024, plus a further 8-9% in 2025. The Topix is expected to offer some of the fastest earnings growth rates in the developed world over the next 12 months. After the recent sell-off, Topix forward P/E has moderated back to 15x, broadly in-line with 10-year averages. With corporate reform continuing to make progress and management teams increasingly focused on both the return on capital and return of capital to shareholders, multiples have strong potential to re-rate over time.

Our key themes in equity markets are economic reflation and corporate reform. They can particularly benefit specific sectors, namely:

  • Financials: With reflation returning, we expect nominal GDP growth to re-accelerate relative to the past two decades. Financials, and particularly banks, are among the most sensitive sectors to an improvement in nominal growth. We see banks benefitting from a) stronger economic activity that likely translates into greater demand for credit; and b) the expectation that the BoJ will likely tighten monetary policy gradually, raising yields and providing another tailwind to bank earnings and profitability over time.

JAPANESE BANKS ARE BENEFITTING FROM RISING YIELDS

Source: Bloomberg Finance LP.. Data as of March 29, 2024.
  • Consumer Discretionary (ex. auto): Domestic wages are growing at some of the highest levels in over 30 years and we expect this momentum to be sustained as wage growth broadens out and feeds through the economy in the coming months. The increased spending power can drive increased domestic discretionary spending and benefit well-positioned retailers and manufacturers of consumer goods.

RISING WAGE GROWTH BODES WELL FOR DOMESTIC CONSUMPTION

Wage growth, YoY %

Source: Bloomberg Finance LP.. Data as of February 29, 2024.
  • Technology: Japan is one of the global leaders at manufacturing specialized semiconductor capital equipment, components, and tools for the industry. In some cases, Japanese producers have a near monopoly in specific elements of the semiconductor supply chain. With increased capex driven by shifts in global semiconductor supply chains (which benefits Japan), rapidly expanding investments in artificial intelligence advancements, and a nascent cyclical recovery, the sector remains well-positioned for above-market earnings growth in the years to come. 

JAPAN SEMICONDUCTOR SALES EXPECTED TO GROW

Source: World Semiconductor Trade Statistics, Ministry of Economy, Trade and Industry, J.P. Morgan Investment Bank. Data as of December 31, 2023.
  • Industrials: After an 18-month downcycle in global manufacturing, we are finally seeing signs of recovery via U.S. ISM and global manufacturing PMIs. Historically, Japanese industrial companies that specialize in manufacturing capital equipment, robotics, and machinery see an uptick in new orders that results in accelerating sales and expanding margins when global manufacturing PMIs rise. This group of companies can further benefit from a strong USDJPY that improves their competitiveness versus global peers and leads to market share gains.

THE INDUSTRIAL SECTOR SEEING SIGNS OF RECOVERY IN LINE WITH GLOBAL MANUFACTURING PMI

Source: Cabinet Office of Japan, J.P. Morgan Investment Bank, S&P Global, Haver Analytics. Data as of February 29, 2024.
  • Real Estate: Reflation is driving property prices higher in Japan, particularly in the main economic growth engines like Tokyo. Owners of prime real estate stand to benefit from asset revaluation, property sales, and increased rents. Companies that can find ways to unlock value or improve returns on capital by realizing their real estate gains could see further upside.

REFLATION IS DRIVING PROPERTY PRICES HIGHER IN JAPAN

Residential and property price indexes, indexed 2010 = 100

Source: Ministry of Land, Infrastructure, Transport and Tourism, Haver Analytics. Data as of Q4 2023.

Domestic reflation beneficiaries tend to be much less sensitive to currency movements, and their fundamentals are more dictated by domestic demand. Thus, for investors concerned about a meaningful appreciation in the yen, we view banks, retailers, and real estate as segments that would be better insulated from this risk compared to export-oriented businesses.

For general allocations to Japanese equities, we advocate for USD-based investors to manage the currency risks carefully by considering the following:

  1. Hedge out JPY exposure and enjoy the carry. At the moment the Japanese currency runs a deeply negative carry against the USD. By hedging it back to dollar, investors enjoy a ~5% carry on an annualized basis thanks to wide interest rate differentials, and hedge currency risks from the equity position. 
  2. Take JPY loans. Despite an exit from negative interest rate policies, Japan is still the only major economy with near-zero interest rates. By borrowing and investing in the same currency, investors are not taking currency risks.
  3. Hedge against further JPY weakness through structures. For investors holding a view that the JPY is undervalued at the current level, structures allow participation in potential medium-term strength while hedging against downside volatility. We believe hedging is necessary, as risks of an extended period of dollar strength cannot be ignored. 

All market and economic data as of April 25, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

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Indices are not investment products and may not be considered for investment.

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For illustrative purposes only. This does not reflect the performance of any specific investment scenario and does not take into account various other factors which may impact actual performance.

Past performance is not a guarantee of future results.  It is not possible to invest directly in an index.

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Index definitions

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 Consumption Activity Index (CAI), compiled by using a variety of sales and supply-side statistics on goods and services as its source statistics, is provided as a measure for capturing short-term consumption activity on both monthly and quarterly bases. The CAI traces movements of consumption in the household side of the economy, much like those in the Annual Report on National Accounts (ARNA) -- which represents consumption activity in Japan in the most comprehensive manner -- but is made available in a more timely fashion. The CAI shows only small fluctuations emanating from samples rotations, and also exhibits a high correlation with a number of confidence survey measures.

TOPIX-Banks Index is a capitalization-weighted index of all the banks listed on the First Section of the Tokyo Stock Exchange and is one of the 33 industry sectors of the TOPIX Index (TPX). The index was developed with a base value of 1000 as of January 6, 1992. The parent index is TPX.

The JGB 10-year Index is a Legacy Government (Sovereign) Generic Index-key ticker by Bloomberg L.P. for the Japan Government 10-year bond. 

The Residential Property Price Index is an index of prices of residential plots of land and unit ownership buildings. The index is calculated based on data gathered through the System to Provide Real Estate Transaction Price Data (Land General Information System) operated by the Ministry of Land, Infrastructure, Transport and Tourism (MLIT), with the quality of each property adjusted using the Hedonic Approach.

The Commercial Property Price Index is an index of prices for commercial property (commercial plots of land and buildings) nationwide that is calculated based on the data accumulated through the System to Provide Real Estate Transaction Price Data (Land General Information System) operated by the Ministry of Land, Infrastructure, Transport and Tourism (MLIT), and the quality of each property is adjusted by using the Hedonic Approach.

The J.P.Morgan Global Manufacturing PMI is a composite index produced by J.P.Morgan and S&P Global in association with ISM and IFPSM. This index looks at the manufacturing sector, by surveying output and employment intentions of manufacturers. A level above 50 indicates economic expansion, while a number below 50 indicates a contracting economy.

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JPMS is a registered foreign company (overseas) (ARBN 109293610) incorporated in Delaware, U.S.A. Under Australian financial services licensing requirements, carrying on a financial services business in Australia requires a financial service provider, such as J.P. Morgan Securities LLC (JPMS), to hold an Australian Financial Services Licence (AFSL), unless an exemption applies. JPMS is exempt from the requirement to hold an AFSL under the Corporations Act 2001 (Cth) (Act) in respect of financial services it provides to you, and is regulated by the SEC, FINRA and CFTC under US laws, which differ from Australian laws. Material provided by JPMS in Australia is to “wholesale clients” only. The information provided in this material is not intended to be, and must not be, distributed or passed on, directly or indirectly, to any other class of persons in Australia. For the purposes of this paragraph the term “wholesale client” has the meaning given in section 761G of the Act. Please inform us immediately if you are not a Wholesale Client now or if you cease to be a Wholesale Client at any time in the future.

This material has not been prepared specifically for Australian investors. It:

  • may contain references to dollar amounts which are not Australian dollars;
  • may contain financial information which is not prepared in accordance with Australian law or practices;
  • may not address risks associated with investment in foreign currency denominated investments; and
  • does not address Australian tax issues.

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To learn more about J.P. Morgan’s investment business, including our accounts, products and services, as well as our relationship with you, please review our J.P. Morgan Securities LLC Form CRS and Guide to Investment Services and Brokerage Products

 

JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

 

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.