Japan: Is this time different?

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

On the last trading day of 1989, the Nikkei 225 closed at a record high of 38,915.87, bookending Japan’s multi-decade post-World War II growth boom and eye-popping asset price inflation of the 1980s. What followed after Japan’s asset bubble burst was three decades of deflation and anemic growth, as corporates and households paid down liabilities instead of borrowing at near-zero interest rates to invest and spend.

Occasional equity rallies since then have turned out to be head-fakes for investors, and markets were disappointed time and again by tentative efforts at reflation, reform and rejuvenation. Since the end of 1989, the S&P 500 and Euro Stoxx 50 are up 1,334% and 342% respectively (in price return terms), making Japan one of the most notable laggards in global markets.

Last week, more than 34 years later, the index finally closed above that record. The mood seems different now coming off a world-leading rally in 2023 and continued outperformance in 2024. Warren Buffett’s high-profile investments into Japan since 2020 also boosted sentiment. Market enthusiasm is elevated and international investors are starting to invest in Japan, betting that deflation is finally over and corporate governance reforms – first initiated a decade ago – are finally having an impact.

Is this time different?

The improved outlook for Japan appears to be based on two key factors – an exit from long-running deflation (or reflation) and further support from corporate governance reforms. In this note, we detail what these factors mean for the equity market outlook and address the top questions that investors have about investing into Japan.

The strong rally has investors asking whether the market has run too far. We think no, and there is still a strong case for an overweight towards Japanese equities. Continued reflation driven by domestic demand and industrial investment can persist, and corporate governance reforms are likely to continue. Japanese equities are benefitting from multi-year structural factors and could continue to make new highs in the coming quarters on high single-digit earnings growth and valuations moderately above historical averages. Any pick up in global manufacturing activity could be an added cyclical tailwind. Longer-term, we expect potential double-digit equity returns. Uncertainties regarding growth and inflation would likely be met with a patient Bank of Japan (BoJ) that moderates excessive near-term yen strength. This is supportive for equities and presents opportunities for dollar-based investors.

Is Japan finally escaping deflation? Is it sustainable?

The short answer is yes. Japan’s nominal GDP has broken out of a two-decade stagnation and we expect continued positive nominal GDP growth going forward. Inflation has also broadened across the economy and remained above the BoJ’s target of 2% for several quarters.

The long answer is that Japan appears to have both the conditions and willingness this time to truly escape deflation. In the near-term, inflation is expected to ease to 2% in 2024, tempering the need for serious policy tightening. In the coming years, inflation will likely be between 1.5-2.0%, a sweet spot that allows for generally accommodative macro policies.

Importantly, an inflationary mindset has started to take hold amongst households and corporates, evidenced by rising expectations for positive wage growth, which builds a virtuous cycle of rising wages and rising prices (and profits) – a stark contrast to the long-held deflationary stance of past decades that depressed consumption, investment and growth.

Compared with past reflation efforts that were domestic-focused, this time the global backdrop is also favorable. Japan’s industrial sector can benefit from a revival of industrial policies to support capex in semiconductors as a beneficiary of global supply chain reallocation. The government has committed $67 billion to subsidize building semiconductor manufacturing capabilities (an area Japan once dominated which has since declined in favor of other Asian producers). These advantages are reinforced by a large interest rate differential between Japan and other developed markets, which supports borrowing and investments within Japan.

Domestic consumption has not fully recovered to pre-Covid levels and remains a source of upside potential for reflation. More determined efforts by fiscal and monetary authorities to support inflation is an important factor, which they appear to be committed to.

What is the “corporate reform” theme and how can it drive Japanese equities?

In the wake of the asset bubble collapse, households and corporates deleveraged their balance sheets – opting to pay down debt rather than borrow to spend or invest in what is now known as a “balance sheet” recession. As such, many Japanese companies have tended to hoard cash instead of investing for growth, creating a vicious cycle that dragged on growth expectations and corporate valuations. 

Corporate governance reforms are not new in Japan and improvements started taking place in 2014 under a broader set of economic policies now known as “Abenomics”, initiated under former Prime Minister Shinzo Abe. Under those directives, Japanese corporates were required to implement practices such as: calculating cost of capital; explaining why returns did not meet the cost of capital; justifying cross shareholdings; adding more independent directors, etc. Consequently, share buybacks have steadily increased as a form of improving balance sheet efficiency.

Reforms have accelerated recently. The Tokyo Stock Exchange (TSE) has further encouraged increased urgency for Japanese companies to improve returns. A starting point is for companies to acknowledge their cost of capital, and for share price performance to be considered in decision-making. The TSE’s ultimate objective is to encourage active dialogue between Japanese corporates and shareholders in order to improve corporate governance, returns on equity, and valuations. The TSE is looking to publish a list of companies that have responded to such disclosure requests on the 15th of every month. 

Other areas of focus include increased English disclosure and effectiveness of communication with investors. Even for companies trading at high price-to-book ratios (P/B), the TSE has requested that they promote constructive dialogue aimed at improving corporate value over the medium to long-term. As companies meet current requirements, there is an increasing likelihood that the TSE could initiate other measures to further raise the corporate governance bar in the near future. In just the last six months, the percentage of compliant companies has risen to 49% from 31%. We have also started to see a number of prominent companies – such as Toyota – reduce cross-shareholdings as another way of addressing historical corporate governance concerns.

How can we assess the potential upside from corporate governance reform?

Simplistically, if we focus on companies with either net cash or significant cross-shareholdings and a P/B < 1, we estimate this universe at 100-150 corporates. Assuming this group of companies indeed see a re-rating to 1x P/B, this could add over 3% to the index.

Clearly, there is no reason why re-rating needs to stop at 1x (the S&P 500 and Stoxx 50 trade at 4.6x and 2.1x respectively), but it does help to contextualize that the re-rating upside for the market due to corporate governance reforms is likely in the 3-10% range. We believe this offers plentiful opportunities for fund managers that are focused on value or event-driven strategies in Japan to meaningfully outperform.

The market has rallied a lot, how much more upside could there be?

A combination of several compelling factors are presenting structural and idiosyncratic reasons for investors to consider allocating capital to Japan:

• Accommodative monetary policy relative to the developed world
• A re-emergence of domestic inflation
• Corporate governance reforms
• Meaningful re-shoring efforts
• Investors seeking alternatives to China

We believe this is likely to sustain the Japanese equity rally going forward, and we turn more positive on the market, increasing our base case TOPIX outlook to 2,700-2,750 (from 2,420-2,480). Over the next 12 months, we expect earnings to grow 8-9%, driven by semis, consumer discretionary and financials. The price-to-earnings (P/E) multiple can be maintained at 15x, only slightly above 10-year averages.

There is a very plausible case for the multiple to further re-rate as greater evidence of reflation and corporate governance changes materialize. In the years ahead we expect double-digit equity returns, as these structural changes and a stable global economic backdrop support higher potential earnings growth for Japanese corporates. International investors have also just started returning to Japanese equities after many years of persistent outflows, providing some support from a positioning perspective.

If reflation persists, corporate governance reforms accelerate to further drive meaningful operational efficiency improvements, international investors continue to further reduce their underweights, and manufacturing activity sees a cyclical recovery into 2025, it is plausible for the TOPIX to reach levels as high as 2,975-3,025 over the next 12 months, under a bull-case scenario.

But isn’t Japan technically in a recession now? What can drive growth going forward?

Japan saw negative GDP growth in the second half of 2023, but we think it could be a short and shallow recession. Looking under the hood of the GDP print, the primary drag in 2023 was weak household consumption. The upturn in inflation squeezed household spending, as it was not matched by a similar level of wage growth. Looking ahead to 2024, while the export outlook is challenged, domestic demand will likely lend more support to growth, which is dependent on real wage growth.

Real wages will likely turn positive as inflation peaks, while wage growth could be higher and more broad-based. The key catalyst here is a process known as the “Spring Offensive” or (Shuntō), where every March, Japanese unions and employers negotiate wage increases. This offers an important signal for wage-setting by corporates around the country. Expectations are that nominal wage growth could be higher than the 3.6% achieved in 2023 and outpace inflation (now at 2-3%). This could support consumption, which is reinforced by rapidly recovering tourist spending.

The second driver is the policy stance. Fiscal policy is likely to remain supportive in the form of income support and tax rebates, as the government looks to shore up flagging approval ratings. Investments in semiconductors will likely continue in line with a government push to put Japan in the global race to reorient supply chains.

While the growth outlook is moderate, we think Japan’s reflation still has some ways to run. Nominal GDP (which matters for corporate earnings) has also continued to grow even as real GDP is weak, in another sign that the transition to reflation is persisting.

What does this outlook mean for the Bank of Japan?

We think the BoJ can afford to be gradual with monetary policy normalization in order to create more favorable conditions for continued reflation. For decades, the central bank has pursued ultra-accommodative monetary policy, such as quantitative easing (QE) and negative interest rate policy (NIRP) in a bid to reflate the economy, with little impact. However, the pandemic spike in inflation has broadened and Japan appears to be on a steadier reflation path, prompting expectations that the BoJ can finally exit its unconventional policy stance.

Many say that persistent inflation and soft growth (a ‘stagflation’-type scenario) posts a dilemma for the BoJ. We believe this is an ongoing balancing act, and recent weak economic data has validated their gradual approach to normalization. As the economy goes through a soft patch, more patience is warranted.

More sustained reflation, particularly in domestic demand, will likely be an important pre-condition for continued policy normalization. Assuming the economy moves out of recession, an exit from negative interest rates is our base case for 2024. Even so, real rates still remain highly accommodative and could continue to support investments going forward.

While the possibility of further rate hikes beyond zero cannot be precluded, it is not our base case for this year and current market pricing (~30bps of hikes in 2024) seems aggressive.

What does this mean for the Japanese yen?

Currency is a critical part of the Japan investment conversation, as performance could vary significantly in local currency versus USD terms. While the cumulative three-year total return of 50% for the TOPIX was eye-catching, the same return in USD is much more modest at below 10%.

Over this time period, the yen depreciated over 40% against the dollar and largely wiped out equity gains for investors that did not hedge the currency. Thus, getting the currency right is critical to generating equity returns in Japan. Fundamentally, the transmission mechanism is via export earnings in overseas currencies, which are translated back into the yen.

The key driver of the yen is interest rate differentials, or carry. The 10-year U.S. Treasury (UST) – Japan Government Bond (JGB) rate differential has explained over 80% of movements in USDJPY over the past two years. This explains the sharp deprecation in the yen since 2022 when the Fed embarked on aggressive rate hikes, while the BoJ maintained easing.

We think the yen could strengthen modestly against the dollar over the next 12 months. With USDJPY at 150 at the time of writing, we think the room for the yen to weaken is limited, as we see some verbal intervention efforts from Japanese authorities. Historically, the Ministry of Finance has instructed direct market interventions to defend the currency around 148-152.

There could be more clarity that the Fed has finished hiking and that U.S. interest rates will likely trend lower, while JGB yields could hold or grind modestly higher, narrowing the interest rate differential. That said, investors may need to be patient – any yen strength is less likely to happen before the second half of 2024 when we expect the Fed to start delivering rate cuts.

In the meantime, investors have to be mindful of currency exposure. Yen cash has zero yield, and the carry against the dollar is around -5%. This means for USD-based investors, hedging the yen back to the dollar provides a “free” 5% and could be attractive. Borrowing in yen is also viable due to low interest rates – by borrowing and investing in the same currency, investors do not take significant directional FX risks.

What are the downside risks to consider when investing into Japan?

Aside from a stronger yen, there are other factors that could cause Japanese equities to pull back:

• Global manufacturing activity is weak, and this has historically led to negative earnings revisions for Japanese equities. There is some moderate earnings downside risk if this weakness is protracted. In addition, in the event the U.S. enters a recession, the Fed would likely cut rates aggressively and lead to an additional headwind for Japanese equities due to meaningful appreciation in the yen and weaker external demand.

• With increased investor excitement in Japanese markets, valuation multiples have also re-rated. Both historically and relative to the Euro Stoxx 600 (another historically cyclical index), Japanese equity valuations are near 10-year highs. With currently overbought conditions and increased valuations, we could see tactical pullbacks in the market. A marked improvement in global sentiment on China, though unlikely in the near-term, could also lead to some reversal of flows from Japan back to China.

• Inflation concerns have led Prime Minister Kishida’s approval ratings to fall to levels that led to both his two predecessors resigning. The Japanese equity market has historically performed poorly when a reformer (such as PM Kishida) loses power due to uncertainty over future policy direction.
• Skeptical investors reasonably maintain that Japan remains a slow-growing economy with fundamental challenges, such as poor demographics and global competition, which clouds its long-term economic outlook. Thus, an active and approach to investing into Japanese equities is essential for capturing upside growth opportunities.

So how should I go about investing into Japan?

The thesis for stronger equity market performance is based on idiosyncratic and structural developments that can boost certain segments of the economy and markets while unlocking greater shareholder value from its corporations.

From a portfolio perspective, most global investors have been underweight Japanese equities for years. Within the context of a globally-diversified portfolio, we are constructive on closing those structural underweights and moving to a slightly overweight allocation.

All market and economic data as of February 28, 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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Index definitions

The Nikkei-225 Stock Average is a price-weighted average of 225 top-rated Japanese companies listed in the First Section of the Tokyo Stock Exchange. The Nikkei Stock Average was first published on May 16, 1949, where the average price was ¥176.21 with a divisor of 225.

The Standard and Poor's 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941-43 base period.

The EURO STOXX 50 Index, Europe's leading blue-chip index for the Eurozone, provides a blue-chip representation of supersector leaders in the Eurozone. The index covers 50 stocks from 12 Eurozone countries. The Index is licensed to financial institutions to serve as underlying index for a wide range of investment products such as Exchange Traded Funds (ETF), Futures and Options and structured products.

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.

STOXX Europe 600 Index (SXXP Index): An index tracking 600 publicly traded companies based in one of 18 EU countries. The index includes small cap, medium cap, and large cap companies. The countries represented in the index are Austria, Belgium, Denmark, Finland, France, Germany, Greece, Holland, Iceland, Ireland, Italy, Luxembourg, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.