The Japanese stock market has been performing well in 2023, with the TOPIX recently reaching another post-bubble high. Yet some investors, perhaps fearful of another false dawn in Japan, doubt whether it can last much longer.
While that view is understandable, the profound changes occurring in Japan make us less wary of the phrase "this time is different". In many ways, it already is: the Japan Value index, for instance, is at an all-time high, having surpassed its 1989 peak.
We believe there are three key reasons for investors to feel optimistic about Japanese equities as we look ahead to 2024 and beyond.
Japan is finally dealing with deflation
Things have been fixed in Japan for so long – prices, wages, demographic growth – it has seemed like an ice age. But that is now changing rapidly, with prices and wages both rising, which is particularly encouraging news for equities and property – both historically good inflation hedges.
The Bank of Japan (BoJ) is the only central bank in the world that wants to create inflation and it has its foot on the pedal as hard as possible. Inflation is now close to a 40-year high – 4.3% – which is a huge tailwind. The BoJ, fiercely determined to end structural deflation and create higher nominal GDP and higher wages, does not want to miss its chance by prematurely tightening monetary policy.
Whilst we may well see some gradual moves towards normalisation over the next 12 months, the process will likely be slow and rates will likely remain lower for longer, an environment that should be beneficial to domestic risk assets.
The contrast between Japanese monetary policy and the rest of the world remains stark. While there is no certainty around when ultra-loose monetary policy will change, the determination to break from structural deflation is real, and the market environment, irrespective of BoJ actions (or inactions), remains supportive.
Governance revolution just getting started
Japan’s much-heralded corporate governance revolution received an extra boost this year from the Tokyo Stock Exchange (TSE) when it pledged to name and shame companies with a price-to-book of less than one. That is still nearly half the market: 45% of companies within the TSE Prime Market fall into this bracket.
Not every company is going to turn into Microsoft because of this policy, but it means that corporates must try to improve shareholder value. This means we will start to see higher dividends, more share buybacks and more break-ups of the sprawling conglomerates common in Japan. Hitachi, for instance, has done an impressive job of selling the parts of its business that were less profitable or non-core, and we expect many others to make meaningful efforts to improve their return on equity and share price performance.
TSE policy has already had a significant impact on market returns, with Japanese value stocks benefitting most. We see no reason why the market should not continue to respond positively to corporate efforts to improve shareholder value. The TSE has crossed the Rubicon with its reforms, and there will be no going back.
Japan remains very attractive versus the US
Since 2003, Japan’s equity market performance relative to the US, in dollar terms, has been woeful. The comparison since QE began in the US in 2008 is especially unflattering, with technology and growth stocks relentlessly propelling the US market higher.
In our view, however, this outperformance has probably come to an end, as we are now in a world of structurally higher interest rates and inflation. That makes Japan much more attractive, particularly as the market remains very depressed relative to the US.
The weak yen, now at a 52-year low in real trade weighted terms, is key to this. Today, on a medium-term view, it seems likely that the yen is going to strengthen – and that may start to lead to better performance from the Japanese equity market relative to other major markets.
For now, it remains early days. When Abenomics started in late 2012, TSE trading volumes surged higher as foreign buyers invested around $250 billion into the market. As a result, the Nikkei doubled. Most of that money flowed back out in subsequent years and it has only now started to come back in. This time around, we think that foreign investors will continue to buy and that we are only at stage one of this process. Neither the big US institutional investors nor Japan’s domestic institutions have yet come in, and it will matter when they do.
Crucially, for these investors and others, valuations are not inflated. On a price-to-book basis, the TOPIX remains low relative to history despite the recent rally. Indeed, its valuation is roughly in the middle of its range since the Lehman shock in 2008, and significantly below where it was in the 1990s and early 2000s. On that basis, valuations are no impediment to the appeal of the asset class. Investors considering Japan have not, in our view, missed the boat.
Jeff Atherton is the lead manager of Man GLG Japan CoreAlpha Fund
