Active Thinking: Japanese equities shining brighter

Goro Takahashi and Lukas Knüppel, Investment Directors, Japan Equities, explore how various global and domestic factors have contributed to an optimistic outlook for the Japanese equity market.

4 December 2023

The Japanese equity market has been one of the best performers so far in 2023, with the Tokyo Stock Price Index (TOPIX) up 25.9% year-to-date as at 27 November 2023. This outperforms the S&P 500 index, which is up 18.5% over the same period. One of the reasons for the strong market performance is the value rally in Japan. We have seen consistent outperformance of value over growth and quality, and the driver behind this spread is the upward movement of the US interest rate and the Japan Exchange Group (JPX)’s Initiative. JPX requested listed companies to improve their return on equity (ROE) and also the price-to-book ratio (PBR), with a focus on companies with lower ROE and lower PBR and that are in the value category. While value stocks have been outperforming growth stocks, we believe growth and quality stocks are also poised for a bright future, given that US interest rate is peaking out and that growth and quality stocks are better positioned to prove their earnings power and capital efficiency.

Bank of Japan’s policy shifts and wage outlook in Japan

In Japan, the combination of high input costs due to increased prices of imported raw materials and loose monetary policy has led to a depreciating yen. This has triggered inflation in Japan after three decades, which is welcome news for Japan’s policymakers since it allows its economy, mired in decades of stagnant growth and deflation or disinflation, a chance to break out by triggering private investment-led growth.

As Japan is witnessing inflation for the first time in decades, it could be an opportunity for the Bank of Japan (BoJ) to move to a path of interest-rate normalisation. Japan's Finance Ministry might raise the assumed interest rate paid on bonds in the government's annual budget proposal for the first time in 17 years in fiscal year 2024, reflecting policy shifts by the BoJ that have allowed yields to rise. The BoJ policy is expected to hike rates slightly next year, although it will not be as dramatic as we have seen in the US or in Europe. However, there is still a small uptick in yields in Japan; the banks in Japan have also performed quite well in the past two years in anticipation of this. Should the BoJ raise rates next year, this would be quite a contrast to what we are expecting from other central banks, the Fed, and the European Central Bank, where we expect them to reduce rates next year. Hence, we think the yen currency will strengthen next year.

Although there is a growing expectation that the BoJ may end its long-standing negative interest rate policy in 2024, it also depends on the wage outlook going forward, which is uncertain. Despite the continuous inflation over the past two years, the wage hike has lagged behind, resulting in a decrease in real wages. Large listed companies have announced wage hikes, which is a positive sign for the economy. However, it remains to be seen if such hikes will happen in mid to small-cap companies as well. Once we can confirm the recheck nationwide, the BoJ will have more options in terms of controlling negative yield.

Industrial Robotics and Machine Tool Orders in Japan

One of the key indicators of the industrial sector in Japan is the monthly statistics of industrial robotics and machine tool orders. These reflect the demand and investment in automation and manufacturing, which are essential for the competitiveness and innovation of Japanese firms. The charts below show the year-over-year growth rates of these two statistics, as well as world semiconductor sales, which are important for both the Japanese equity market and the Japanese economy.

Japan – Robotics orders

World – Semiconductor sales by region

1 year percent change, 3-month average (left), absolute (right), WSTS data

As we can see from the charts, industrial robotics and machine tool orders have been in a down cycle for the past two years, reaching lows comparable to the 2020 Covid crisis. However, we expect they will show a recovery soon, as the fundamentals continue to improve. We have heard from our portfolio companies that they are making progress in the inventory correction, which means that they have reduced the excess stock of their products and are ready to ramp up production and sales. This is also supported by the strong uptake in the world semiconductor sales, which indicates a robust demand for electronic components and devices, especially from the semiconductor production equipment sector, where Japan has a significant exposure.

The service sector in Japan has also been doing very well this year, as the country has recovered from the Covid pandemic and resumed its normal activities. One of the most notable signs of this recovery is the tourism industry, which has bounced back to the pre-Covid levels of foreign visitors. This is a positive development for the Japanese economy, as tourism contributes to the consumption and employment growth, as well as cultural exchange and diversity.

Another factor that affects the performance of Japan equities is commodity prices and logistics costs, which influence their input costs and margins. These have been on a downward trend since the peak in mid-2021, which was driven by the supply chain disruptions and the pent-up demand after the lockdowns.

We expect that this trend will continue in 2024, as supply chain issues are resolved and demand normalises. This would provide a tailwind for companies, as they would benefit from lower input costs and higher profitability. From a fundamental perspective, we are positive for the next two years in terms of earnings growth.

Positive Outlook

The outlook for Japanese equities is favourable, in our view as many stocks are currently attractively priced, on both a relative and an absolute basis, with improving corporate governance and growth. For investors, we feel this presents a compelling opportunity to capitalise on the tailwinds supporting the Japanese equity market.