After three decades of being shunned by international investors, the Japanese stock market is attracting renewed interest this year. It has been among the top performing markets, with the Nikkei 225 index posting a gain of 18% to the highest level in 33 years. The rise has been accompanied by increased buying by foreign investors including Warren Buffett, who recently added to his stakes in five large trading conglomerates to $15 billion.
Some investors are hopeful that stricter enforcement of governance standards will be positive for shareholders. Hiromi Yamaji, the new head of the Japan Exchange Group, has stated that companies should implement Japan’s Corporate Governance Code by looking more carefully at their price-to-book ratios, capital costs and share price, while also engaging in a “constructive dialogue” with shareholders.
The renewed interest in Japanese stocks, however, is not being driven by a dramatic change in Japan’s economic performance. After recovering from the Covid-19 pandemic in 2021, the economy has been expanding close to its long-term potential rate of 1%. On the positive side, the Bank of Japan has not had to raise interest rates, because inflation remains acceptable at about 3%.
Rather, the new-found interest in Japanese equities reflects three main considerations.
First, after decades of underperforming the U.S. market substantially, Japanese stocks now offer good relative value (see chart). For example, based on Barclays’ calculations of cyclically-adjusted p/e (CAPE) ratios, Japanese stocks are cheap compared to U.S. stocks, whereas they had been much more expensive previously. Japanese companies recognize this, and the corporate sector has been the largest net buyer of Japanese stocks.
CAPE Ratios: US vs Japanese Stock Market (orange: Japan / blue: US)
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Second, the 15% depreciation of the yen versus the dollar during 2022 improved the international competitiveness of Japanese companies. While the yen has appreciated so far this year, it is still cheap on a purchasing-power-parity basis as inflation in Japan is well below that in the U.S.
Third, Japan is benefiting from heightened tensions between the U.S. and China, which have caused international investors to diversify away from it. Accordingly, some investors view Japan as a safe way to play China’s growth. A recent article in the Financial Times notes that seven of the world’s largest semiconductor makers have made plans to increase manufacturing and deepen tech partnerships in Japan.
So, does this mark a turning point in which the Japanese stock market will outperform after it stagnated while US stocks soared ten-fold in the past 30 years (see chart)?
Performance of the Nikkei 225 vs S&P 500 indexed to Q4 1992
Strategists at Goldman Sachs and Maquarie Group believe the case for a bull run is solid, and they are recommending Japanese stocks to investors. However, many institutional investors, including BlackRock
, the world’s biggest asset manager, are not convinced this marks a fundamental turning point. In fact, the majority of institutional money managers are still underweighting Japan relative to their global benchmarks.
The principal reason is that institutional money managers are waiting for Japan’s policy thrust to become clear before committing funds to Japan. As one UK based investor told Reuters, “Big money never buys cheap, it buys momentum.”
My own take is that investors need to be clear about whether they view Japanese equities as a short-term tactical play or a long-term strategic play. The case for investing in Japanese stocks tactically is compelling for the reasons cited previously: Namely, both the stock market and currency are cheap on a relative basis and Japan stands to benefit from heightened geo-political tensions with China.
That said, there is no indication that Japan has recouped the dynamism that made it a formidable economic rival to the U.S. in the 1970s and 1980s. Unlike the U.S., which overcame oil shocks in the 1970-early 1980s and a series of asset bubbles in the past two decades, Japan has struggled since its stock market and real estate bubble burst in the early 1990s. In fact, the Japanese stock market is still about 20% below the peak level reached in 1989.
Several forces have been at play. One is policy mistakes: The Bank of Japan kept monetary policy too tight for too long which ultimately gave rise to deflation. While Prime Minister Shinzo Abe sought to end the “deflationary mindset” with more expansionary monetary and fiscal policies and a program of structural reforms, they were only partially successful. It remains to be seen whether this mindset will change now that inflation has picked up in the wake of the Covid-19 pandemic.
A second force is demographics: Japan not only faces an aging population but also one that is declining. As a result, its rate of economic growth has slowed considerably while its saving propensity is higher than most other developed economies. Thus, Japan’s potential growth rate is likely to remain at about one per cent.
The third force is China’s emergence as a super-power both economically and politically, in which it has overtaken Japan as the most important country in the Asia-Pacific region. Because of the heightened geo-political tensions today, this is one area where Japan may be able to regain some of its former standing.
In short, the rally in Japanese stocks may continue for a while longer on the back of foreign buying. However, the key consideration longer term will be Japan’s ability to make its economy more dynamic. The verdict on this issue is still out, as domestic investors reportedly have been net sellers of equities in the past two months.