Diverse Outlook
After more than three decades, Japanese equities have hit record highs, but does the asset class have more room to run?
Zurich head of macroeconomics Guy Miller says: “I have been in markets since 1991 and I was on the US equity desk, and back then everyone was bullish on Japan. Any money people made in US equities back then was deployed into Japanese equities. It has taken 34 years to get back to the record level.”
“Two things have really happened there — one is the weakness of the yen, that has been a big factor. The second is around corporate governance — the unwinding of cross shareholdings and better use of shareholder capital. None of those things are particularly new, but it’s a case of a lot of things coming together.”
Yen weakness has the effect of boosting the earnings potential of Japanese exporters, and enhancing the returns available to those whose primary currency is not the yen.
Morningstar Investment Management chief investment officer Mike Coop has been taking some profits on Japanese equities, but remains keen on the asset class.
Third arrow of ‘Abenomics’
He told FT Adviser: “Japan’s reforms have been happening for the past seven or eight years, and we have been overweight to there for a good while. The reforms that are making a difference now were the third arrow of the ‘Abenomics’ policies announced in 2012, but it has taken this long for the market to realise the change that is happening.”
Abenomics was a series of three broad policies implemented by former Japanese Prime Minister Shinzo Abe.
Branded as the “three arrows”, one arrow focused on looser fiscal policy, one on looser monetary policy, and the third on corporate sector reform.
It is the changes associated with the third arrow that Coop and others say are having a profound impact on Japanese equities. He believes the changes are profound because they will improve companies’ earnings potential.
Comment on the quality of the Japanese market, Coop says the fact it has taken 34 years to beat the precious high is as much a function of “how crazy valuations got in the 1980s”.
The reforms that are making a difference now were the third arrow of the ‘Abenomics’ policies announced in 2012, but it has taken this long for the market to realise the change that is happeningMike Coop, Morningstar Investment ManagementOne of the arguments cited by those more sceptical of the durability of the Japanese equity rally is that it is a function of inflation rising in the country.
Advocates of that view say that while Japan’s ageing population ensured very low inflation, investors in the country were content to own US or other developed market government bonds because the yields, while low, were still positive in real terms, and so there may be no need to buy equities.
But in more recent times, Japanese inflation has risen above zero per cent, and Miller says that such a change could prompt the Bank of Japan to move beyond its long-standing zero interest rate policy.
Any upward move in interest rates would be expected to lead to strengthening of the yen, and that could be negative for equities, notes Miller.
But Coop says slightly higher inflation helps the balance sheets of Japanese companies, particularly those with debt, and improved balance sheets may justify higher equity valuations.
For this reason he feels that Japanese equities can continue to perform well.
Macro matters
From a macroeconomic perspective, Miller says one issue that has been a negative for many years is that Japanese technology companies “underinvested” in innovation for many years and so lost their advantage relative to large US and other Asian firms, with those businesses developing smartphones, for example, where Japanese companies were left behind.
He says that for the longer-term issues in the Japanese economy, the level of capital investment needs to increase.
On the impact of monetary policy, Premier Miton multi-asset fund manager David Jane says that he hedges the yen exposure in his funds, which should help to mitigate any damage to returns from higher rates, while some sectors such as banks will benefit.
We think the rally in Japan and elsewhere in Asia should continue as the bull market broadens away from the Magnificent SevenDavid Jane, Premier MitonHe adds: “We like Japan, it’s our second-biggest region after the US. Lots of reasons, first, the valuation and reform argument — here, we have a lot of very good value mid-caps, which have been profitable but trade on very good valuations compared to other regions. Low price-to-book [ratios], strong balance sheets, etc.
“We also have some big-cap tech such as Tokyo Electron. Broadly, we think the rally in Japan and elsewhere in Asia should continue as the bull market broadens away from the [Magnificent Seven technology stocks]. It only takes a small amount of Nvidia gains to be reinvested in these markets to make a big difference.”
Amundi Investment Institute head of global equity strategy Eric Mijot is another who believes in the bull case for Japanese equities.
He says the rally has largely been inspired by improved earnings growth from Japanese companies, and that aggregate earnings grew by more than those of the US market in both 2022 and 2023.
Mijot agrees that the onset of somewhat higher inflation in Japan is likely to boost equity returns.
Policy response
TS Lombard economist Dario Perkins says that after a decade where the world had taken the view that inflation would be structurally lower in Japan, and that the rest of the world was heading in this direction, markets have started to price in inflation being higher, both globally and in Japan.
He believes the outlook for Japanese equities will be heavily influenced by how policymakers in the country respond to the new normal.
Perkins says one of the risks is that the Bank of Japan lifts interest rates too soon in order to combat inflation, and reduce the growth rate in the economy.
On the corporate side, he says that for the economy to grow, the reforms discussed above will have to work, and also that the private sector comes to expect such changes to be permanent in nature.
Nikko Asset Management chief strategist Naoki Kamiyama notes that the Japanese economy slipped into recession in the fourth quarter of 2023, and that this has the capacity to dent stock market returns.
He says the key to returns from here will be whether consumption picks up, as wages have been rising at less than the rate of inflation, but that as inflation has come down, so real wage growth has been restored.
Kamiyama adds that this may be needed in order to maintain equity market growth.
david.thorpe@ft.com
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