We see opportunities in select sectors, but we do not expect Japan’s stock market to boom or its bond yields to increase dramatically.
Ian Schaeffer, Global Investment Strategist
When we think about investing in Japan these days, we see two new tactical opportunities worth exploring: in-bound tourism and the island’s battery industry. But we do not believe the country’s bond yields or its stock market will rise as much as others currently do.
Tourism in Japan is surging and has the potential to boom—thanks in large part to a relatively inexpensive yen, pent-up demand and the world’s “post-pandemic” travel spree. Another potential bright spot: The country’s battery and mineral producers could benefit from new U.S. legislation that incentivizes a transition to “clean” energy.
Of course, we’re also watching the big picture—and are struck by how fretful some investors now are about Japan’s bonds and excited about its equities:
- Some bond investors are concerned by the rise in longer-term Japanese government bond (JGB) yields. The fear is that—if Japan’s bond yields rise a lot more—Japanese bond investors could be diverted to their domestic market and away from their historic role as outsized buyers of other nations’ bonds, which could hurt the bond markets globally.
- Many equity investors are increasingly optimistic about Japan’s stock market. Over the last year, Japanese equities have been outperforming U.S. equities. Some of the most exuberant investors now expect a rising sun for Japanese equities, postulating that Japan’s deflation problem has been solved at long last and a new secular bull market for Japanese stocks is dawning.
Both camps should moderate their outlooks. We don’t think JGB yields are likely to increase enough to shock global bond markets (our managed portfolios have only a moderate allocation to JGBs). We also believe secularly weak domestic demand in Japan is likely to continue to drag on the country’s stock market generally (our managed portfolios have a neutral allocation to Japanese stocks.)
For now, our expectations are more enthusiastic for tactical investments in Japanese tourism and batteries.
Here’s a closer look at our thinking:
Tourism in Japan is rebounding—and has room to run
Only recently did Japan start welcoming world travelers back again. It wasn’t until May 2023 that the Japanese authorities downgraded the health risk from COVID-19 to that of a typical seasonal influenza.
Japan’s reopening, coupled with a relatively inexpensive yen, is helping inbound tourism surge. Official data on inbound international airport passenger traffic is available with a lag. We also examined J.P. Morgan Private Bank card spending data to track tourism trends through June. Both indicators show a sharp uptick, but our card data, based on local restaurant spending in Japan, shows a greater surge and suggests rapid growth may continue in the coming months.
Investors might consider a range of tourism-related stocks in Japan—from some of the largest including airline companies to others, such as major shopping entertainment venues.
Making the investment attractive: Tourism stocks in Japan are generally undervalued these days. Even though Japanese tourism stocks have risen by about 15% YTD, this solid performance still lags the broader market (Topix).1 From a valuation perspective, tourism stocks in Japan are valued more attractively than they were before the pandemic, at about a 2% discount (considering the forward price-book differential versus Topix).
The potential for growth is promising, with many more visitors possible from both China and the United States.
Japan’s current rebound in tourism spending has been happening largely without a meaningful influx of Chinese tourists, as Japan and China have been at an impasse this year over both nations’ visa restrictions. However, discussions are seeking to establish a mutual visa exemption system that could boost Chinese tourism spending in Japan.2
Meanwhile, Americans are on the move–with a record number intending to travel overseas soon. According to the U.S. Consumer Confidence data from the Conference Board, Americans’ stated intention to travel to foreign lands is at the highest level ever recorded (and the data goes back to the late-1960s).3
Moreover, many Americans might be lured to Japan, given how strong the U.S. dollar currently is against the yen. Considering data back to 1972, the yen is currently about 1.4 standard deviations undervalued relative to the U.S. dollar.
Japan’s battery sector could benefit from the U.S.’s Inflation Reduction Act
This March, the United States signed a free trade agreement with Japan, focused on critical minerals such as lithium, nickel, manganese and graphite. This agreement came on the back of the U.S. Inflation Reduction Act (IRA), signed into law in August 2022.
As we discussed in a recent article, a major bottleneck to the U.S. energy transition is the sourcing of critical minerals, of which China has a dominant market share globally. Moreover, built into the IRA is a commitment to increase the U.S. supply of critical minerals; subsidies are available when minerals are mined or refined in a country with which the United States has a free trade agreement (that does not include China).
Japan fits the bill extremely well. After China, Japan is the second-largest producer of synthetic graphite in the world. Synthetic graphite is widely used in lithium-ion batteries as anode material (where energy in a battery is stored and discharged). To be sure, some battery producers are experimenting with next-generation technologies that do not use synthetic graphite; however, the scaling of next-generation anodes in production might be at least a decade away.4 For now, Japan’s synthetic graphite industry stands to benefit from the IRA as the logical substitute for Chinese production.
Investors should consider Japanese mineral producers (of synthetic graphite), as well as Japanese battery producers—especially those that have a manufacturing presence in the United States (which allows them to take advantage of IRA tax credits that are expected to help boost profitability).
Investors also might look at companies that are currently building and/or expecting to build plants in the United States. When considering such an investment, look at the company’s earnings guidance to see if it is factoring in expected profitability boosts from IRA subsidies.
Even as investors might find some real opportunities in Japan’s tourism and battery sectors, we’d caution against exaggerative narratives about Japan’s stock and bond markets more broadly.
See the full picture for Japan’s bond market and buyers
Yes, JBG yields have recently risen and could go a bit higher—but we think the increase is likely to be limited, and we don’t foresee it creating a global domino effect.
In late July, Japan’s central bank made a major change to its seven-year-old policy of yield curve control (YCC) that kept rates within half a percentage point above or below zero. Last year, the Bank of Japan (BoJ) had committed to defend the rate cap of 0.5% with unlimited bond buying. But in July 2023, the BoJ switched from that rigid limit, indicating it is comfortable with yields of up to 1% (the new hard cap).
On this news, JGB yields rose about 20 basis points (bps) to 0.65%—the highest level since 2014, when YCC began. This jump spurred global bond yields to move higher; the 10-year U.S. Treasury yield rose about 25 bps over the same time period (at the end of July/early August) to 4.15%. The reason: It was thought that higher yields at home might cut into Japanese investors’ longstanding appetite for U.S. Treasury bonds.
Global bond investors worry this ripple effect may just be getting started if YCC is not just loosened but eventually abandoned altogether. Japanese domestic investors hold a large share of international debt securities. According to data from the International Monetary Fund, Japanese investors held 13.6% of U.S. long-term bonds and 8.5% of global bonds in 2021.5 The concern is that as JGB yields rise, it could become more attractive for Japanese investors to buy domestic fixed income securities rather than international securities.
But we believe two key points should temper this fear:
1. It hasn’t been attractive for a while for domestic Japanese investors to buy international bonds. Since about late 2021, when you include the cost for converting currencies and hedging the exposure, domestic JGBs have offered Japan-based investors 40 bps more in yield than U.S. Treasuries.
Why has Japan’s economy become vulnerable to externally driven inflation?
Japan became a major oil and gas importer when public opinion turned against nuclear energy after the 2011 Fukushima disaster. Among the major nations, Japan now runs the largest energy trade deficit. This is the context in which the 2022 global energy price spike hit the Japanese economy hard.
The deterioration of Japan’s real wages also indicates that external forces are driving the country’s inflation. Real wages (i.e., wages adjusted for inflation) are down by more than 5% from Q4 2019 to Q2 2023. In contrast, real wages in the United States are up nearly 3% over the same period.
Another important comparative point: the United States used fiscal policy to stimulate its household sector much more than Japan did. Subsequently, U.S. domestic demand has greatly outperformed Japan’s (in USD terms).
We believe that because the BoJ understands these dynamics well, it is in no rush to tighten monetary policy to quell externally generated inflation. At the latest monetary policy meeting in July, BoJ Governor Kazuo Ueda went out of his way to stress that allowing JGB yields to rise above 0.5% should be seen as “enhancing the sustainability of monetary easing rather than tightening.”
Markets have gotten the message. Even after the BoJ’s YCC tweak, the yield differential between the United States and Japan is still historically wide (and the same is true for forward interest rate contracts). The BoJ is remaining accommodative, which should keep the yen relatively inexpensive so as to boost growth (in tourism and exports) and counteract weak domestic demand.
So fears about bonds getting hit globally, catalyzed by Japan? We think that’s unlikely. We wouldn’t be surprised to see JGB yields drift up toward 1% over the next couple of months or quarters; after all, markets historically have tended to challenge the caps central banks set. But as the external inflation shock eventually fades, the underlying driver of weak domestic demand in Japan (amid challenging demographics) should reassert itself.7
Don’t expect a secular bull market for Japanese equities anytime soon
According to J.P. Morgan Research, global investors have been structurally underweight Japanese stocks since 2002.8 We believe this structural underweight won’t be closed until there are clearer signs that domestic demand in Japan is improving, and that inflation is rising for the right reasons. The same differential we showed above between domestic demand in Japan and that in the United States (in USD terms) has over the long run tracked relative equity market performances.
In our managed portfolios, we are currently neutral in our allocation to the Japanese stock market. We are taking this position, despite a weak demand backdrop in Japan, because:
- Japan (like Europe) offers international exposure relatively inexpensively, serving as a diversifier to U.S. stocks, which have become pricier YTD. On a forward price-earnings basis, Japanese stocks trade about 1.2 standard deviations undervalued relative to U.S. equities.9
- Japanese listed companies serve primarily a domestic market, unlike the European market in which its investors are more susceptible to global risks (and rewards). The foreign revenue exposure of the Topix is just under 35%, while it’s 30% for the S&P 500. But for the STOXX Europe 600, it’s over 50%. In the period of hyper-globalization from the late 1990s through the 2000s, this exposure worked to the benefit of risk assets in Europe. But now, de-globalization risks are elevated, and we think competition from China climbing up the manufacturing value chain likely poses a greater risk to Europe than it does to Japan.
Already we have seen Germany’s trade surplus in autos fall from around 15% of GDP in 2016 to just over 11% today. Meanwhile, China’s trade surplus in autos has soared. For the first time ever, in Q2 of this year, China’s auto trade balance with the European Union flipped from deficit into surplus.
- The Japanese stock market provides a “value” factor tilt that, we believe, is underappreciated. Many investors currently feel overexposed to the growth factor (due to the exceptional rise of mega-cap tech stocks). But in Japan, growth stocks have underperformed value. Indeed, since 1995, value has outperformed growth by 120% in Japan, and we expect this trend to continue. Meanwhile, in the United States and Europe value has underperformed growth by 53% and 7%, respectively.
Famed value investor Warren Buffett has noticed. He recently upped his stake in the Japanese equity market, raising Berkshire Hathaway’s holdings in Japan’s five main trading companies to 8.5%, from 5% in 2020.10 Berkshire also has signaled its intention to raise that stake to 9.9%, the upper limit beyond which would require specific approval from Berkshire’s board of directors.11
- Corporate governance reforms that seem to be underway might have the potential to enhance shareholder returns.
Return on equity (RoE) measures have been chronically low in Japan compared to the United States and Europe, which has coincided with Japanese companies hoarding cash (equal to 17% of the Topix index market cap, versus 4.5% for the S&P 50012). Governance reforms were a key pillar of “Abenomics” (named after the late Prime Minister Shinzo Abe) dating back to 2014, but progress has been slow.
However, notably, earlier this year the Tokyo Stock Exchange demanded listed companies to investigate low RoEs and asked them to address weak capital profitability with an analysis, including targets, timelines and measures to improve their returns on capital and market valuations.13
Citi Research has done an analysis estimating the RoE lift then could come from less cash holding and greater shareholder prioritization among Japanese corporates. The conclusion: If Topix cash levels were reduced to the level of the S&P 500, and cross shareholding in Japan were reduced by 50%,14 it would lift the RoE of the Topix by nearly two percentage points to 11%.15
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To learn more—and to explore whether and how judicious investments in Japan might support your financial goals—speak with your J.P. Morgan team.
1 Driven up by semiconductor stocks on the strength of global enthusiasm for artificial intelligence, the Topix is up 25% YTD (semiconductor stocks in Japan have risen 72%). Data as of August 2023.
2 “China Requested Japan Allow Visa Free Entry, Business Group Says,” Bloomberg News, July 6, 2023.
3 Data as of June 2023.
4 Evelina Stoikou, “Emerging Battery Technologies Hold Key to Next Wave of EVs: BNEF,” Bloomberg New Energy Finance, June 16, 2023.
5 IMF’s Coordinated Portfolio Investment Survey. Data as of 2021.
6 A caveat here is that core inflation has been held down this year to an extent by fiscal subsidies, specifically for household electricity and gas bills. These subsidies began in January of this year and are set to go through at least October, and likely have held core inflation down by about 100 bps in the YoY rate. See: Ayako Fujita, Benjamin Shatil and Yuka Mera, Japan 2023 Economic Outlook, J.P. Morgan Research, December 1, 2022.
7 We’ll be watching, most importantly, the real wage growth dynamics in Japan for signs that the BoJ’s policy normalization might become anything more than extremely gradual.
8 Rie Nishihara and Yong Guo, “Global investors’ Japanese stock positions: Will underweighting be resolved?,” J.P. Morgan, June 15, 2023.
9 Considering data back to 2005.
10 These five trading companies are: Itochu Corp., Marubeni Corp., Mitsubishi Corp., Mitsui & Co., and Sumitomo Corp. The phrase “trading company” is a bit of a misnomer here, as these companies have evolved from their historical roots of importing commodities and food into Japan. Today, they have built up business interests in everything from logistics to real estate, to finance, to aerospace. See: “What Warren Buffett is buying in Japan’s Berkshire Hathaway look-alikes,” CNBC, May 5, 2023. The percentages refer to Berkshire’s holdings of all the stocks issued by the Japanese trading companies (as opposed to the share of Berkshire’s total stock investments). Note: References to companies in this article are not intended as either recommendations nor endorsements by J.P. Morgan in this context.
11 "Buffett Boosts Stake in Japan Trading Companies as Shares Surge." Bloomberg Financial L.P., June 19, 2023.
13 “Action to Implement Management that is Conscious of Cost of Capital and Stock Price,” Exchange & beyond, Tokyo Stock Exchange, Inc., March 31, 2023.
14 Cross shareholding refers to a business practice where two or more companies hold shares in each other’s stock. This may be done to establish strategic alliances and enhance mutual financial support. However, in Japan, cross shareholding was historically designed to insulate managements from any threat of a hostile takeover and to avoid rather than confer shareholder rights. Today, it is widely acknowledged that cross shareholding in Japan effectively weakens the urgency of corporate governance reforms and hinders the maximization of corporate value.
15 Ryota Sakagami and Ken Miyahara, “Japan’s corporate governance reforms now seeking real results,” Citi Research, May 11, 2023.