Land of the rising funds

Japan finds itself at an inflection point, with equities finally back up to 1990 levels, and inflation on the rise after decades of deflation. But impending policy decisions by the Bank of Japan (BOJ) will test the market’s resilience.

As of summer 2023, Japan’s Nikkei 225 index and Tokyo Stock Price Index (Topix) are savouring 33-year highs, and the market’s consumer price index (CPI) of 3.5% indicates that it has finally broken free of decades of chronic deflation and limited growth.

Warren Buffet’s recent endorsement of  Japanese equities adds to the positive sentiment. On a visit to the country in April, he commended the core business strategies of the country’s five largest trading companies (sogo shosha), comparing them to his globally acclaimed investment firm, Berkshire Hathaway.

“They are really so much similar to Berkshire. They own a lot of different things,” he told media in April, after raising his shareholdings of Itochu, Marubeni, Mitsui, Mitsubishi and Sumitomo, to 7.4%. In late June, he increased his stakes further, to an average of 8.5% across them.

A big driver of the market rally has been its recent overhaul of corporate governance practice, which started under late prime minister, Shinzo Abe, and has seen revision through publication of an updated code of practice, observers told FinanceAsia.

“The aim [of corporate governance reform] is to improve the efficiency of corporate structure and thereby raise the return on invested capital – for example, by unwinding inefficient cross-shareholding structures, and by holding management to greater account for financial performance,” Frederic Neumann, chief Asia economist at HSBC, explained.

The Tokyo Stock Exchange (TSE) has advanced these efforts by implementing valuation reform and by applying pressure on corporates to come up with action plans to raise their price-to-book (P/B) ratios. A January report revealed that for roughly half of TSE-listed companies, this figure typically sits at less than 1%.

Action being taken by Japanese companies includes introducing share buybacks – the popularity of which is at its highest for 16 years – and introducing gender equality policies.

As of June 2, 2023, 5.5% of constituents of the MSCI Japan Index had no female director, a notable improvement over 29.8% in 2020, MSCI’s Asia Pacific (Apac) corporate governance research lead, Moeko Porter, told FA.

“The combination of regulatory and investor pressure will likely continue and drive further governance improvements,” she said.

To some extent, Japan has benefitted from the geopolitical tensions at play elsewhere in the region, suggested Naka Matsuzawa, chief strategist across Japan macro at Nomura. He noted that investors are turning to Japan in search of safe havens away from China and Taiwan.

Graph of historic performance of Nikkei 225

Source: Nikkei

“Particularly for US investors, Japan is a safe place in which to allocate capital,” agreed Masahiko Ishida, co-country managing partner for Japan at DLA Piper.

Geopolitical shocks have prompted supply chain diversification, which offers advantage to Japanese firms active in the semiconductor industry, added Kensuke Niihara, chief investment officer for Japan at State Street Global Advisors.

With valuations remaining attractive, analysts believe that the stock market could climb further.

According to Bloomberg data, the Topix is trading at a P/B value of 1.3 – the lowest among G7 countries and around a third of the 4.1 P/B value of the S&P 500.

“We believe more long-term foreign investors will invest in the Japanese market when corporate governance improves more materially and capital efficiency is realised. Therefore, it’s reasonable to expect further upside after the recent rally,” said Niihara.

What is Japan’s YCC?

Maintaining yields within a target range through bond purchases is known as yield curve control (YCC). YCC differs from quantitative easing (QE) in that the latter does not target a specific interest rate.

To tackle years of stubborn deflation, in 2016, the BOJ introduced a -0.1% target for short-term interest rates and a 0% target for 10-year Japanese government bonds (JGB). The BOJ achieves this by buying bonds to supress yields (since higher demand pushes bond prices up and lowers yields).

Since 2016, the BOJ has made small adjustments to its policy, most recently in December, when it widened the target band on 10-year JGBs, from 25bps to 50bps.

In January, the central bank bought a record 23.69 trillion yen ($182 billion) in JGBs to defend its target, drawing criticism that it was distorting the market.

An upward trend in inflation, coupled with pressure on the yen, has put further pressure the BOJ to end its controversial YCC.

It was expected that BOJ would eliminate its policy shortly after Kazuo Ueda ascended in April as 32nd leader of the central bank and became the first academic to take its reins. However, so far, he has signalled policy continuity and analysts have adjusted their expectations as a result.

The BOJ is only likely to make radical changes to monetary policy when deflationary risks have been fully eliminated, suggested Neumann. Weak real wage growth further supports maintaining YCC.

Meanwhile, Matsuzawa predicts that the end of Japan’s YCC would likely start with an enlargement of the 10-year JGB band, sometime after July. Rate hikes would be likely to follow between spring and summer next year, he added.

“Only if yen weakness continues could the BOJ feel pressured to think about policy modification earlier,” added Niihara. 

Monetary policy at a cross

But at a time when almost all major global economies  are hiking interest rates, Japan’s zero-rate monetary policy –  which has so far supported its equities rally – sticks out like a sore thumb.

Rising inflation and the continued weaking of the yen are two factors putting pressure on Japan to reverse its controversial yield curve control (YCC).

At time of writing, the Japanese yen continued to hover at around 140 to the US dollar, marking a stark contrast to its 95 yen-to-dollar valuation 10 years ago.

“Japanese monetary policy is normalising from a decade of being ultra-loose and I think equities can still perform well during this transition, though there could be some initial bumps,” David Chao, global market strategist for Apac (ex-Japan) at Invesco, told FA.

“I think that the biggest risk to Japanese equities as they near bull run territory, could come from the BOJ abandoning YCC.”

Chao pointed to the negative impact on US equities in the months following the US Federal Reserve’s first tightening in March 2022: “US stocks fell into bear market territory as the Fed raised interest rates by over 500 basis points in just 12 months.”

A change in policy and rise in discount rates would put similar pressure on Japanese equities and their valuations, as bonds become more attractive, he argued, noting that valuations fall when the discount rate used to calculate present value of future cash flows increases.

Dry powder redirection

Another possible repercussion of ending YCC and higher rates, could be the repatriation of institutional capital back to Japan.  However, experts remain divided on the direction of impact for Japanese equities.

Since the introduction of YCC, Japanese insurers and pension funds have invested in funds abroad in search of yield. With $1.36 trillion in assets under management (AUM) as of the end of December 2022, Japan’s Government Pension Investment Fund (GPIF) is the world’s largest public pension fund and has allocated nearly 50% of its portfolio to foreign stocks and bonds, according to its most recent performance report.

The end of Japan’s YCC policy would increase the attractiveness of local Japanese bonds for domestic investors and could reduce their demand for FX-hedged overseas bonds, particularly US dollar- and euro-denominated government and corporate bonds, explained Niihara.

“Higher local bond yields in Japan could pose small headwinds to Japanese equities,” added Neumann.

DLA Piper’s Ishida agreed that any repatriation would likely benefit domestic corporate bonds, while a strengthening yen would be negative for exporters:

“My impression is that abandoning YCC would have an overall negative impact on the stock market, because the yen strengthening against the US dollar would impact Japanese manufacturers unfavourably,” he said.

Other experts held more neutral views, highlighting that a widening of the YCC band would not sharply diminish the yield differential between Japan and other developed markets.

“It is important not to overstate the impact that this move would have,” Neumann told FA.

Meanwhile, Matsuzawa noted that any large repatriation would only be likely once 10-year JGB yields reach 2%, which could be expected after the BoJ raises interest rates next year.

Aging population remains a concern

Even if Japan manages to successfully adjust monetary policy without dampening its stock market, the country faces a number of long-term threats to sustainable GDP growth – notably, labour shortages due to its low birth rate and ageing population.

Nomura’s Matsuzawa noted that the recent push towards increasing female participation in the workforce is as much driven by desire to address this shortage, as it is marketed as ESG progress.

In addition to tapping an underutilised female workforce, Japanese companies will need to improve their talent management practices and pursue technological solutions to improve productivity, reiterated Porter.

Ishida called for more open immigration policies as well as investment in artificial intelligence (AI) to boost productivity.

“Even by boosting productivity, the country will struggle to sustain economic growth unless its birth rate picks up,” said Neumann.

Sustaining the momentum

All eyes will be on the BOJ over coming months as it is forced to abandon YCC and works to bring monetary policy in line with that of its global peers.

At its latest meeting on June 16, the central bank voted to maintain its YCC policy unchanged, weakening the yen to 141.22 against the dollar.

A slow and gradual adjustment – as predicted by analysts – will be key to avoiding large shocks. But as long as corporates continue on a path to reform, observers expect equities to continue their outperformance during any transition period, even if there are some short-term bumps along the road.

Tailwinds in the form of domestic spending, which has so far supported Japan’s GDP growth of 2.7% between January and March this year; as well as bets on a revival of the market’s tourism sector; and inflows from the market’s semiconductor industry as a result of global geopolitical tensions, are set to support the Japanese economy for the remainder of 2023 and into 2024.

However, for real wage and GDP growth to sustain over the long term, the government will need to address greater social issues.

“Cyclically, re-openings in Japan and China support economic recovery. Several structural trends also make the Japanese market attractive to foreign investors, such as wage increases, TSE reforms and supply chain diversification…. In the long term, more open discussion around immigration or an increase in overseas workers will be crucial, but it’s not promising for now,” concluded Niihara.  



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