Good Morning,

 

The Nikkei 225 just passed its record high reached 34 years ago, despite the Japanese economy being in recession.

 

So what are the factors behind investors’ enthusiasm, despite the underwhelming macroeconomic backdrop ? How should investors be positioned ?

 

Japanese Stocks Have The World’s Attention

Japanese stock indexes have risen dramatically for the past 18 months. The Nikkei 225 recently broke its 34-year high. The TOPIX, a more modern index based on market capitalization, had already broken out of its long-held trading range in June 2023.

 

Several factors conspired to attract investors’ attention to Japanese equities:

 

• The return of inflation: Having endured bouts of deflation in the past two decades, inflation made a welcome return after the COVID-19 pandemic. This heralded a sea change in corporate behaviour, enabling companies to increase prices and suggesting profitability could improve.

 

• Corporate governance reforms: The Tokyo Stock Exchange introduced important corporate reforms last year, a follow-up to reforms introduced under former Prime Minister Shinzo Abe in 2012.

 

The government shamed the corporate sector for its notoriously low returns and demanded change. As a result, many companies adopted more shareholder-friendly measures, improving disclosures, growing dividends, and announcing share buyback programs.

 

Many companies are dismantling old cross shareholdings structures (when companies own shares of other companies), freeing up capital that can be used to improve returns: Toyota Motor reduced its stake in telecom company KDDI, Fujitsu sold its chip packaging subsidiary Shinko Electric, while Nippon Steel and Hitachi have announced similar restructuring plans.

 

More To Come

According to a Tokyo Stock Exchange list issued last month, only about one-third of the companies trading on the exchange have announced plans to improve shareholder returns. By divulging company names and using peer pressure, the Tokyo Stock Exchange will encourage more companies to announce plans improve shareholder returns.

 

The results of the reform are already apparent.

 

According to Bloomberg, 60 % of companies trading on the TOPIX now trade above book value, up from 50 % a year ago.

 

The Japanese government recently revamped the Nippon Individual Savings Account (NISA), a tax-free stock investment program for individuals, by expanding annual investment limits and granting indefinite tax-exemption periods.

 

• As of September 2023, 52.5 % of Japanese households’ financial assets were held in cash, or almost twice the size of the Japan GDP. NISA could drive domestic retail demand for stocks.

 

• In a world of increased geopolitical tensions, Japan may be seen as a proxy for investing in China.

 

Calmer Waters

The Tokyo Stock Exchange reforms are an attempt to shake up a corporate sector suffering from a disappointing domestic economy. After a promising H1 2023, Japan’s economy finished 2023 on a sombre note.

 

Q4 2023 GDP numbers pointed to a 0.1 % quarter-over-quarter contraction, on the heels of Q3’s more severe 0.8 % contraction. Weak domestic demand kept inflation at bay.

 

Yet there are reasons to believe the outlook will stabilize.

 

Monthly trade data and economic indicators such as the Tankan Business conditions, both manufacturing and non-manufacturing, suggest that business conditions across all industries were the strongest in five years.

 

Japan also benefits from efforts to friend-shoring and re-shore. This trend allows Japanese companies to extract themselves from Chinese supply chains and build capability in strategic industries on its allies’ terrain.

 

The trend is particularly apparent in the semiconductor industry with both a joint venture between Taiwan’s TSMC and Japan’s Sony, and government support of its own local semiconductor industry.

 

Positive real wage growth should also help consumption recover. Already at 3.6 % last year, wage growth will likely accelerate as labour shortages and high corporate profits entice companies to increase wages and secure the necessary labour force. A Nikkei survey of CEOs suggests that 80 % of them expect wage growth between 4 and 9 %.

 

This spring’s Shuntō annual wage negotiations, during which thousands of unions will simultaneously negotiate wage agreements with employers, will be key to watch.

 

A Very Fine Line

The Bank of Japan (BoJ) has been hesitant to tame above-target inflation by ending its long-held negative interest rate policy for fear of knocking its already subdued economy further off course. Yet, maintaining a loose monetary policy is markedly weakening the yen, contributing to inflation.

 

Inflation above the 2 % target for close to two years, as is the case in Japan, would have spurred most western central banks into a tightening cycle. But the BoJ is moving very carefully.

 

Memories of tenacious deflation are still fresh, given Japan’s mature population (average 49 years old vs. 39 in the U.S.). Hiking rates too quickly could risk crashing the economy, whereas loose monetary policy has markedly weakened the yen, close to 40 % against the U.S. dollar, since 2021.

 

For context: 10-year yields on Japan sovereign bonds, below 1 % compared to 4.2 % in the U.S.

 

A weak yen has been a boon for exporters but a headache for importers, and it is fueling inflation. The BoJ is mulling over its first rate hike in 16 years. Markets are priced for a 0.10 % rate hike by June and a full 0.25 % by year end. Such careful moves are unlikely to throw the economy off course.

 

With other central banks cutting rates this year, the interest rate differential with Japan will diminish. This would alleviate pressure on the yen. The Yen currently trades at 150 to U.S. Dollar. RBC Capital Markets’ forecast is that it could reach 145 to the U.S. dollar at year end 2024.

 

Bloomberg consensus expectation is for Japan’s GDP growth to reach 0.8 % this year, suggesting Japan will emerge from its technical recession.

 

Early Stages

An overweight position in Japanese equities can be seen as prudent. One would expect a period of consolidation following the recent strong rally, but TOPIX earnings growth could increase by a strong 10 % in 2024, according to Bloomberg consensus, driven by the corporate governance reforms and the return of inflation as consensus forecasts we have discussed.

 

Valuations remain in line with the 20-year median, at 15.9x this year’s earnings. This is in contrast to several other equity markets such as the U.S. and emerging markets which trade much above their long-term median valuations.

 

Preference should be given to consumer sectors as higher real wages should encourage consumption, selective stocks in the financial sector as slightly higher interest rates should help profitability, and high dividend stocks that could benefit by retail fund flows under the new tax-efficient investment scheme.

 

As always, please let me know if you have any questions or comments.