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Active Thinking: Japan – Are we finally at a turning point?

In recent months, Japanese equities have surged to all-time highs, fuelled by factors including corporate reforms and foreign inflows. Now, what lies ahead? Ernst Glanzmann, Investment Director, Japan Equities, examines the current landscape, where growth expectations continue to ride high.

18 April 2024

The recent surge of Japanese equities can be attributed to several factors, in our view, including corporate reforms, robust corporate earnings, Japan’s evolving role as a credible alternative to China and greater participation from retail investors. However, one crucial top-down element cannot be overlooked: the weakness of the yen.

The weakness of the yen and the Fed policy

Chart 1: USD/JPY

Past performance is not an indicator of future performance and current or future trends.
Source: Source: Refinitiv Datastream, as at 17 April 2024.

The yen’s depreciation is primarily driven by the difference in interest rates between Japan and the US. Since March 2022, the US Federal Reserve (Fed) has aggressively raised its key interest rate from near zero to 5.25% (lower band) to combat rising inflation. Higher interest rates typically make a currency more attractive to investors, leading to less demand for currencies with lower rates, including the yen.

Japan has faced unique economic challenges, while its economy has stagnated over the last three decades. Demographic challenges, such as low birth rates and an aging population, have further hindered economic growth. Despite these difficulties, Japan is aiming for 2% inflation after years of deflation. Given the country’s unique situation, rising inflation, though challenging for consumers, is viewed positively by policymakers. For nearly 25 years, Japan refrained from intervening in the global currency market. However, in the autumn 2022, authorities stepped in to support the yen. Despite these efforts, the yen’s weakness has persisted.

Why is the yen still weak? As stated above it is largely due to Fed policy. Last year, many anticipated multiple rate cuts by the Fed throughout 2024. However, this narrative has changed. Now, the market is pricing in fewer than three rate cuts in the US for this year (compared to the initial expectation in early January of six rate cuts).

Rate hike and all-time highs

In the wake of the Covid pandemic and Russia’s invasion of Ukraine, Japan experienced a surge in prices from the spring of 2022 onwards, partly fuelled by a weak yen. Japan’s core inflation rate (excluding volatile food prices) rose to 2.8% year-on-year (YoY) in February 2024. During this year’s ‘shunto’ wage negotiations, Japan’s largest employers agreed to an average wage increase of 5.3%, marking the most significant boost since 1991. Such wage hikes can have a direct impact on consumer spending and overall economic activity.

In March, the Bank of Japan (BoJ) made a historic decision by ending its controversial negative interest rate policy after 17 years. It has now raised its policy rate out of negative territory, establishing a new target range of 0.0-0.1%. This move reflects the BoJ’s efforts to adapt to changing economic conditions and stimulate growth. Japan’s central bankers and government officials now assert that the nation stands at a pivotal moment. Companies are poised to pass on increased costs to consumers through higher prices and consequently workers are demanding better pay. Prime Minister Fumio Kishida declared “Japan is facing a once-in-a-lifetime opportunity to get out of deflation. Let’s establish rising wages as the new norm across society.”

Meanwhile, in February this year the Nikkei 2251 stock index surpassed a previous peak reached 34 years ago, signalling renewed investor confidence in Japan’s economy and financial markets. The initial excitement was quickly followed by questions: Is the market once again in bubble territory? We remember the lessons from the past.

The answer could lie in the striking contrast between the late 1980s bubble era and today. During that peak period, Japanese shares accounted for a staggering 45% of the global stock market, surpassing even the US, which stood at 33%.2 The Tokyo Price Index (TOPIX)3 100 Index was trading at an astronomical 70 times its earnings over the trailing 12 months.4

Chart 2: TOPIX valuation by market cap

Past performance is not an indicator of future performance and current or future trends.
Source: Source: Refinitiv Datastream, as at 17 April 2024.

Despite reaching new highs and experiencing a remarkable 18% increase since the beginning of the year (as at 8 April, 2024), the TOPIX 100 currently trades at approximately 17 times its earnings, as measured by the price-to-earnings (P/E) ratio. Despite the robust performance of Japanese equities, with the Nikkei 225 and the TOPIX Index achieving all-time highs, the overall valuation remains relatively low compared to historical levels. We believe that the surge in Japanese equities is not merely a repetition of a bubble; rather, it reflects a more balanced and sustainable economic expansion with moderate inflation.

Is Japan at a turning point and what does it mean for investors?

Japan has recently celebrated the conclusion of a nearly 20-year deflationary cycle, while the country’s shrinking population continues to be a matter of concern. The ingredients for a positive long-term narrative remain and provide opportunities for investors. Semiconductor-related names and related sectors have been driving market performance, aligning with global trends of rapid advances in the use of artificial intelligence. The automotive sector, with its balanced product portfolio, is well-placed to capitalise on the shifts in preferences of consumers who are reluctant to commit fully to the purchase of electric vehicles. Finally, Japanese companies stand out for their highly varied machinery offering, which allows them to take advantage of trends in different global economic sectors. However, we are cognisant that Japanese stocks remain sensitive to fluctuations in the yen’s strength, and the market’s ties to the S&P 500 and central bank policies add to the volatility.

Foreign investors have noticed significant advancements in Japanese firms, fuelled by enhanced corporate governance standards and efforts by the JPX Tokyo Stock Exchange to boost corporate stewardship. These improvements, along with a heightened emphasis on the cost of capital and a more shareholder-friendly approach to capital usage, have helped the recent rally. There is still room for these efforts to continue. However, restricted liquidity remains an issue, so for now buying interest is still focused on larger capitalisation companies and market breadth has remained narrow. Despite these challenges, unique investment opportunities are emerging, enabling investors to acquire high-quality companies at reasonable prices. There was significant outperformance of value stocks in 2023, especially in the banking sector, but we believe certain growth stocks could play a prominent role from a long-term perspective. In many cases their earnings growth prospects shine brightly, but they have often been overlooked by investors in recent years.

1 The Nikkei 225 is used around the globe as the premier index of Japanese stocks. More than 70 years have passed since the commencement of its calculation, which represents the history of Japanese economy after the World War II. Because of the prominent nature of the index, many financial products linked to the Nikkei 225 have been created and are traded worldwide while the index has been sufficiently used as the indicator of the movement of Japanese stock markets. The Nikkei 225 is a price-weighted equity index, which consists of 225 stocks in the Prime Market of the Tokyo Stock Exchange. (Source: Nikkei).
2Source: Reuters
3TOPIX is a market benchmark with functionality as an investable index, covering an extensive proportion of the Japanese stock market. TOPIX is a free-float adjusted market capitalisation-weighted index. TOPIX shows the measure of current market capitalisation assuming that market capitalisation as of the base date (January 4 ,1968) is 100 points. This is a measure of the overall trend in the stock market, and is used as a benchmark for investment in Japan stocks. (Source: Japan Exchange Group).
4Source: Refinitiv Datastream.
Important disclosures and information
The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

Ernst Glanzmann

Investment Director
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