This year it seems everyone is going big on Japan. The Tokyo Stock Exchange is soaring with the Nikkei 225 hitting a 33-year high in June, surpassing the psychological 33,000 barrier for the first time since the country’s decades-long deflationary spiral first began to take hold.
Anecdotally, foreign investors are pouring into the country, most typified by Warren Buffett, who announced earlier this year he was adding to his shareholdings of Japan’s five trading houses – Itochu Corp, Marubeni Corp, Mitsubishi Corp, Mitsui and Sumitomo Corp.
The rubberstamp of approval from the Oracle of Omaha has only added credence to the theory that after previous false dawns, where foreign investors have flooded into Japan only to later give up in frustration with the country’s incorrigible corporate sector, this time will be different.
The arguments in favour of Japan are too numerous to mention in their entirety, but include the re- emergence from Covid, rerouting of supply chains away from China, tax reforms including the expansion of the NISA programme, and the country’s relative political stability (the ruling LDP defeated its opponents in a landslide in last year’s elections).
Above all else though, the one factor that comes up time and time again in conversations with Japan watchers is the country’s corporate governance reforms.
Japanese corporates, which have long hoarded cash (according to Charles Schwab, this has reached $2.5trn) are finally showing signs of putting this to work. May was the biggest month for buybacks on record, according to Morningstar.
A lot of the impetus towards improved corporate governance has come from top-down reforms. Tokyo’s stock exchange is promoting the soft requirement for a price-to-book ratio greater than 1x, which currently only half of the country’s listed companies manage to achieve.
Unsurprisingly, given this benign backdrop, investment flows into Japan have soared. According to Morningstar data, overall net inflows to Japan hit ¥946.3bn ($6.51bn) in July, the largest monthly amount this year.
For equity funds, the momentum was even more impressive as both Japan and world equities more than doubled their net inflows compared with the previous month, coming in at ¥168.4bn and ¥453.5bn, respectively.
The question now being asked by Japan watchers is whether we have already reached the peak or whether there is further to go and the elephant in the room is the country’s unconventional monetary policy, also known as yield curve control policy.
In 2016, the Bank of Japan (BOJ) introduced negative interest rates, but also crucially introduced yield curve control as well. As the name suggests, the policy is designed to control the shape of the entire yield curve, not just short-term rates.
At the end of July, the BOJ tweaked its yield curve control policy by effectively saying that it would tolerate yields on 10-year Japanese government bonds as high as 1%.
The move on the face of it should make for bad reading for Japanese equities because of the potential for higher discount rates on future earnings as well as a stronger yen (the export-dependent Topix tends to move inversely with a stronger currency), but most Japan watchers think that it is not so straightforward.
Japan, which recorded a second-quarter annualised growth rate of 6%, is now the fastest growing economy in the G7 and what is more after years of being caught in a downward price spiral is starting to see the re-emergence of inflation even when food and energy costs are stripped out.
Market watchers argued that insofar as there are signs that the BOJ may be beginning to unwind its ultra-loose monetary policy, this was only because of the country’s benign macro backdrop, which was good for equities and valuations currently do not look too stretched, allowing for the rally to continue further.
“The BOJ is only allowing long-term rates to rise because the outlook for future nominal GDP growth has changed in the direction of higher NGDP growth, which is positive for future earnings growth,” said Michael Makkad, senior equity analyst at Morningstar.
“The price/earnings ratio for the Japanese market, relative to consensus TOPIX EPS, is around 14x, so as long as the earnings outlook stays decent I don’t think the market is overextended.”
Despite this, Japan watchers said that investors would need to be selective going forward if they were to continue to benefit from the rally. Most of this has been concentrated towards the larger cap names, although there are ample opportunities among small and mid-cap names.
“As confidence builds, you’d expect capital to search for cheaper situations and that’s very much at the small, mid-cap end of the spectrum. What you’ve seen in the early parts of the rally is capital flowing in, it’s typically been driven by large cap value. There are names that are very familiar to global investors. They don’t have to do that much research. If they want to play the theme, it’s park capital into banks, for example, which have been a very strong feature of the rally,” said Joe Bauernfreund, chief executive officer and chief investment officer of Asset Value Investors.
“As they become less touristy when it comes to Japan, they spend more time researching and understanding the market and they’re gaining confidence, you’d expect to see a trickle-down effect.”
This story first appeared on our sister publication, Portfolio Adviser.
