Japan's on a roll. Is it for real this time?
Why we think Japan could finally outperform after three lost decades.
Japan has been burdened for over a generation with high debt, poor demographics and entrenched deflation. Its equity market has experienced several head fakes since peaking in early 1990. Midway through 2023, however, it’s been a different story. Up roughly 20% YTD, the Nikkei 225 is trading at a 33-year high as investors take note of a deluge of factors big and small that are benefitting the world’s third-largest economy. This isn’t the first time that savvy investors have been able to turn a profit in Japanese equities since the Nikkei reached its high-water mark in late 1989 (when Japan represented more than half of the MSCI EAFE Index). But there are reasons to believe this run could be the most sustainable.
Looking back, Japanese equities rallied in 2000 during the Internet craze when Japanese companies were on the cutting edge. It happened again in 2004, when the reform policies of Prime Minister Junichiro Koizumi (who reinvigorated a moribund economy after a “lost decade” following its late 1980s collapse) and massive quantitative-easing programs by the Bank of Japan led to predictions of the long-awaited death of deflation (which just never quite came to fruition). Finally, Abenomics and the “three arrows” policy of monetary and fiscal stimulus and structural reform broadened the labor market, increased corporate transparency and restored consumer confidence after the global financial crisis.
But the common denominator in all three cases was their brevity. Each post-bubble equity market rally fizzled, generating disappointment and skepticism about Japan’s ability to pull itself out of its prolonged funk. So, investors may be excused for wondering if this time is any different. We think it may be, which is why our top-down country allocation model has made Japan our largest overweight in our international equity growth strategy. And we have been on the ground visiting companies and engaging with policymakers more than three times since November.
Japan headwinds could turn into tailwinds
The deflationary headwinds confronting Japan have been around for decades. It’s one of the oldest societies in the world and getting older; national birthrates are at an all-time low. A constrictive immigration policy hasn’t helped. And a historically strong yen has hurt the viability of Japan’s exports, causing offshoring to such production hubs such as Taiwan, Thailand and Vietnam.
But while these demography-driven constraints remain, external factors appear to be providing necessary shock treatment. Market disruptions spawned by the Covid-19 pandemic and exacerbated by Russia’s invasion of Ukraine propped up energy prices, jump-starting inflationary pressures in a country that’s dependent on imported energy. Wage increases look to be structural, with recent pay negotiations surprising to the upside. Additionally, the dovish BoJ has been an outlier, helping make exports relatively more competitive. On the geopolitical front, Japan is benefitting from a move away from China and basking in the glow of the international spotlight after hosting this year’s G7 and Quad summits. The Warren Buffet effect hasn’t hurt either as foreign investors have flocked to the market.
All in all, the future looks bright(er)
To be sure, some of these improvements almost certainly are priced into the markets, so we wouldn’t be surprised to see some profit-taking in coming months. Even so, the yen is extremely undervalued and equity valuations remain compelling relative to both history and to other global markets. (More than half of Japanese companies are trading below book value.) Further, with the first summer travel season since Japan lifted its Covid-related travel ban last October, resurgent tourist activity already is apparent—and that’s not even accounting for China, whose world-minded travelers are just starting to trickle in after the lifting of Zero-Covid lockdowns.
The question of whether this rally can prove sustainable in many ways depends on the BoJ. It’s been holding steady in the face of increasing inflationary pressures, and late last year broke with a 6-year-old policy of holding the 10-year government bond yield near zero. With the recent appointment of economist and former BoJ member Kazuo Ueda as its head, we think the yield control policy’s phaseout is a matter of when, not if. When it happens, it could pose a catch-22, with equity markets initially suffering while the yen rallies as domestic investors scramble to repatriate funds. Over time, however, those conditions should favor banks and other domestic Japanese firms that stand to profit from a stronger yen and a robust labor market.
Another factor making Japan incrementally more positive is an upcoming regulatory change designed to improve shareholder outcomes and increase retail investor activity. Late Prime Minister Shinzo Abe pushed provisions to bolster the competitiveness of Japanese equity markets through improved stewardship and corporate governance, many of which weren’t fully adopted until this decade. The moves, which in April 2022 prompted the Tokyo Stock Exchange to restructure into three new market sections aimed at improving visibility, liquidity and governance, should force Japanese companies to put to productive use the piles of cash they have been hoarding.
Is it China’s turn to experience a ‘lost decade?’
More broadly, with its equity market conditions improving, Japan could emerge as an effective China counterweight and proxy, offering exposure to Asia with fewer geopolitical and regulatory risks. In fact, Japan’s much larger neighbor arguably is at risk of suffering its own “lost decade” as it struggles with many of the same headwinds (big asset price run-ups, over-indebtedness, unfavorable demographics) that Japan appears to be working through. Japan over China? For investors, that would mark a dramatic shift. The question is whether this is finally the watershed moment investors have been patiently waiting for.