Japan has emerged from its lost decades and international investor interest has returned in force to propel the Nikkei 225 stock index into territory not seen since the 1980s. The market looks forward to even further gains. By Nick Herbert.
Japan is back on the radar for international investors. The country has made headlines in recent months, not just because of the rally in its stock market but also due to the end of its negative interest rate policy and taking the first steps in financing its ambitious transition plans.
A combination of factors has contributed to the resurgence of Japan’s allure for offshore buyers – the magnitude of which can be measured in the performance of the stock market. In February, the Nikkei 225 index breached the 38,915 record level set on the last trading day of 1989. It continued to climb above 40,000.
With foreign investors responsible for as much as 70% of the turnover in Japanese stocks, the market’s rise can be safely attributed to foreign participation.
It might be too simple to assign credit for renewed global interest at the door of Warren Buffet, who, in an interview with Nikkei Asia in April 2023, highlighted Japan as being 'cheap' in comparison to global competitors. But the interview coincided with Japan being ready for business again following the Covid lockdowns. Borders were opening and domestic consumption was making up on lost time. It was good news for the country’s corporates.
"Domestic corporate results have been a tailwind to the stock market performance, with Japanese companies delivering better-than-expected 3Q FY23 results and earnings forecasts being revised upwards," said Chern-Yeh Kwok, deputy head of APAC Equities and head of Japan Equities at abrdn.
Whatever the catalyst, significant levels of foreign money flowed into Japan’s stock market through 2023 and into 2024.
According to Goldman Sachs, the stock market had 10 weeks of consecutive net foreign buying in cash and futures, totalling ¥7.9trn (US$53bn) from April to June 2023. Similar flows were reported into 2024, with foreign investors "net buyers of cash equities for seven straight weeks through the second week of February, bringing their total net buying to ¥2.7trn", according to Kwok. The trend is likely to continue.
Reasons to be cheerful
There are fundamental, structural differences between today and the Japan of 1980s that justify the stock market’s current position and fuel the potential for further gains.
“International interest can be explained by positive macro and micro factors,” said Junichi Takayama, investment director at Nikko AM. “On the macro side, we have Japan finally coming out of its deflationary cycle and, on the micro side, pressure placed on companies by the Japanese government, stock exchange and shareholders to improve corporate governance and focus on shareholder returns is finally paying off.”
One
After years in a deflationary wilderness, Japan is edging closer to a virtuous growth cycle where households are increasingly willing to shoulder the higher prices passed on by corporates and a tight labour market ensures unions are able to negotiate significant wage rises.
Inflation in Japan climbed to 2.8% in February from 2.2% in January. That was proof enough of price pressures building in the economy for the Bank of Japan to raise interest rates for the first time since 2007. In March, it raised its target to the 0.0%–0.1% range from the previous –0.1% figure.
It signalled the end of negative interest rates, the end of a debilitating period for growth prospects, and the end of a psychological malaise.
"As inflation sets in, we believe that the deflationary mindset is gradually changing," said Kwok. "Higher prices are becoming more entrenched, resulting in a firmer domestic outlook for companies."
And while higher inflation has been responsible for real incomes deteriorating over the last couple of years, wages have more recently started to catch up. In March, the country’s largest union group announced that Japanese firms had agreed to increase pay by 5.25% in 2024. That followed a 3.76% rise announced in 2023.
"The results of the wage negotiations represent good news for household consumption and for the ability of companies to pass on price increases," said Takayama. "Higher confidence is shown by companies starting to hike product/service prices, while wage growth is gaining momentum and is expected to bolster consumer activity."
The feel-good factor from higher salaries could provide households the confidence to release excess savings back into the economy – and the stock market. Higher interest rates also incentivise banks to lend again. It all has the potential to drive share price growth.
Two
In 2015, the Financial Services Agency first formulated its corporate governance plan, seeking sustainable corporate growth and increased corporate value. Initiatives to accelerate reform continue to develop.
In 2022, the Tokyo Stock Exchange restructured, tightening its listing requirements, addressing some of the cross-shareholding issues, and enhancing corporate governance.
"TSE reform impetus continues to support investor interest," said Kwok. "As part of its effort to enhance governance improvements in Japan, the TSE has released a list of companies that are taking steps to improve capital efficiency and stock prices."
Almost 60% of companies on the prime market announced they were, or were considering, taking action in response to the request made by TSE to improve management practices with a focus on cost of capital and stock price. The TSE is publishing a list of those companies disclosing information each month, piling on peer pressure to those that do not yet comply.
"You really don’t want to be seen as one of the companies not complying," said Takayama. "You can’t underestimate the impact of naming and shaming in the Japanese culture. It really works."
Companies that most readily comply with the reforms are those being rewarded in the stock market.
In another nod to international investors, new guidelines, applicable to some 1,600 prime-listed companies from April 2025, require simultaneous publication in English of financial statements and timely disclosures.
The changes underpin the wider offshore appeal of Japanese stocks in a market where, despite the recent rally, valuations remain attractive.
"Based on price-book ratios, the Nikkei’s current valuation of 2.0x PBR is a very long way away from its 8.2x peak reached in December 1989," said Kwok.
As more companies conform to disclosure pressure, then it is the older companies with a more traditional approach and the smaller ones that have so far been ignored by investors that promise greater returns in the future.
"There’s still a lot of companies trading below their liquidation value, even after the strong market rally since 2023," said Takayama. "As more companies bow to peer pressure and growing pressure from activist shareholders, we expect these companies to outperform."
Shareholder activism also brings the potential for increasing M&A activity, something that releases even more share value.
Three
A weak yen has already been supportive of the stock market from a relative value basis. The currency still looks comparatively cheap. "The yen is trading at a significant discount on a purchasing power parity basis," said Takayama. "The lowest it has been in half a century."
Analysts expect the yen to appreciate against the dollar in 2024 as a consequence of the Bank of Japan raising rates and the US Federal Reserve easing.
Falling US interest rates are supportive of yen appreciation, but the pace at which the Fed cuts could create problems. Aggressive easing runs the risk of the yen strengthening too quickly – something that could weigh on Japan’s exports, negatively affecting corporate earnings and stock market valuations.
The path to Japan’s stock market for international investors appears well signposted but potential pot-holes lay ahead. Geopolitics has good and bad implications. On the one hand, 'friend-shoring' has led to rising domestic investment from global semiconductor companies, for example, but geopolitics has been responsible for global inflation and high interest rates.
"The over-riding concern is whether inflation persists, rates stay higher for a prolonged period of time, and subsequently global economic growth weakens," said Kwok. "This will have an impact on risk appetite across global markets, including Japan."
But perhaps the most important factor in ensuring international investors allocate more to Japanese equities is corporate reform. "Any disappointment in this area will not be viewed favourably," Kwok warns.
Transition
International support is less assured for Japan’s plans to raise ¥20trn from bonds over the next 10 years to finance its green transformation (GX) strategy. The strategy calls for an estimated ¥150trn in public and private finance to be raised by 2034 to realise the government’s aims to cut greenhouse gas emissions by 46% by 2030 and achieve carbon neutrality by 2050 – as well as grow the economy.
Growing the economy and supporting industry to play its part in the country meeting its Paris obligations is central to the strategy. Japan is taking a very different route to achieving its net-zero targets than has so far been seen elsewhere in the world. It has international implications.
"The plan is a policy for growth," said Justine Leigh-Bell, executive director at Anthropocene Fixed Income Institute. "Japan sees it has an opportunity to lead the transition story, a way to transform its industries to play a principal role in the global green economy. It does not want to be a laggard."
In February, Japan became the first sovereign to issue transition bonds. The five and 10-year bonds raised ¥800bn apiece but there was very little participation from international investors and very little greenium. The lack of international buyers is hardly surprising, given the bonds being auctioned domestically, the currency and the timing of the exercise.
"Domestic investors would have participated for their own purposes," said Xuan Sheng Ou Yong, green bonds & ESG analyst at BNP Paribas Asset Management. "But if you take the view that the Bank of Japan is likely to raise rates, then it may not be the right time for international investors to buy a yen bond."
The biggest obstacle for international buyers to overcome, however, is the proposed use of proceeds from the programme, which includes some controversial elements, such as nuclear power, and a commitment to research and development into as-yet unproven technology.
"It’s unusual for proceeds to be invested in technologies where expected emission reductions or economic viability are unclear," said Nneka Chike-Obi, senior director and head of APAC ESG Ratings & Research at Sustainable Fitch. "That level of uncertainty is a difficult concept for bond investors."
And while the first bonds were structured to reach Climate Bonds Standards by excluding the more challenging investments, it is unclear whether subsequent issuance will conform. The reality is that Japan does not need international investors to finance its transition. "It’s a domestic play," said Leigh-Bell. "Japan is not looking to offshore investors to finance it, but it wants their buy-in in terms of sentiment."
Japan must remain sensitive to the views of international investors for its GX plans. Sovereign dollar bonds are unlikely but hard currency issuance may appear from the export finance agencies as they look to raise capital for transition-focused assets and projects. It also needs the ear of the international community if it wants to play a leading role in the global decarbonisation discussion and in defining transition.
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