Japan’s revival has been one of the stock market success stories of recent years. The MSCI Japan was up 21% in US dollar terms in 2023 and has added another 5.8% in 2024, galvanised by improvements in the Japanese economy and corporate governance reform. But as the economy unexpectedly shrinks in the first quarter and interest rates start to rise, could it derail the enthusiasm for Japanese equities?
The economy unexpectedly shrank in the first quarter, dropping 2% on an annualised basis. The culprit was a weaker consumer, as households reined in spending in response to slower wage growth. Companies also cut spending and exports fell. This has shifted expectations for further interest rate cuts – the Bank of Japan raised rates 0.1% in March for the first time since 2007, but this economic data puts it in a bind. It has also put further pressure on the yen, which has been persistently weak against the dollar.
To lift the currency, the central bank would need to raise interest rates, but doing do could knock economic growth. The BlackRock Investment Institute believes it is unlikely to tighten policy, saying the central banks victory in its decades-long battle against no or low inflation is not yet assured. This means the yen may continue its weakness, at least until the Federal Reserve drops rates.
This has a knock-on effect on the stock market. The rally in the Japanese market has been led by the index heavyweights. This is where incoming international investors have felt most comfortable. However, many of these companies are also large-cap exporters and therefore beneficiaries of the weak yen. They look more expensive than the remainder of the market – particularly small and mid-cap stocks. The MSCI Japan SMID cap index is up only 1% year-to-date, for example, and has dropped 5% over the last month alone.
Idiosyncratic opportunities
Fund managers still see the strongest opportunities beyond the index heavyweights, but recognise there is a chance the ongoing weakness of the yen stops this value being realised. Joe Bauernfreund, manager of the AVI Japan Opportunities trust (AJOT), says: “One fear is currency and interest rates and a fear that a lot of the market rally is driven by a weaker yen. What might lead to that changing? A shift in interest rate policy would help. So far, there has been a slight impact, but the yen has continued to weaken. It is trading with regard to what is going on in the US. Our portfolio is 80% domestically-focused and would benefit from an appreciating yen.”
He continues to focus the AJOT portfolio on those areas where structural reform can deliver share price performance. He adds: “Money has flowed into large cap, which has outperformed small and mid cap throws up opportunities and we are certainly more interested in that part of the market.” He believes confidence will ultimately trickle down.
Alec Cutler, manager of the Orbis Global Balanced fund, has maintained an overweight position in Japan, but adjusted it in response to market movements: “We have rotated a lot in Japan. Japanese banks have been fantastic for us. They’re not fully valued, but banks might be the exception to the ‘hold your winners’ rule. We’ve rotated into the Korean banks, because Korea has looked at what Japan has done and is doing the same.”
His preferred holding in Japan is now Nintendo. “Nintendo is where Disney was in 2005, just before Disney started to monetise its properties. Nintendo has incredible content and an incredible user base and the company hasn’t monetised any of it ever. It owns half of Pokémon and hasn’t never taken any profit from it. The Mario movie shows the power of their games.” He holds around 2.5% of the portfolio there.
Bauernfreund says the corporate governance reforms continue to have an effect and are likely to do so for some time. Again, this is more beneficial for companies outside the index.
He adds: “There is more corporate activity and more pressure on companies to do more to unlock value.” He still sees plenty of value around. He holds the Keisei Electric Railway Company, which – in addition to its railway franchise – has a stake in Oriental Land, Tokyo’s equivalent of Disneyland. The stake is worth more than the share price of the company.
Strong fund flows
There are other factors that may help realise the value elsewhere in the market. International investors continue to be enthusiastic about Japanese equities. The IA Japan sector drew in £145m ($185.5m) in March (source: Investment Association) from UK investors. In April, Japanese equity ETFs recorded $6.9bn inflows globally, its largest monthly inflow since June 2023 (source: BlackRock).
Equally, there are hopes that domestic investors in Japan, who have traditionally been extremely cautious, will turn to the stockmarket to protect themselves against inflation. The BlackRock Investment Institute points out that the Japanese government has also put in place a number of initiatives to encourage more domestic savers to invest and this could boost flows into Japanese stocks and could be directed to more domestically-focused companies.
BlackRock remains bullish on the region. It says: “Japan’s growth outlook remains positive, corporate reforms are taking hold and rising wages can support consumer spending. Ultimately, yen weakness is mainly due to the gap between Bank of Japan and Fed policy rates. The yen could recover once the Fed cuts. We stay overweight Japan’s stocks.”
It also sees a number of mega forces – big structural shifts driving returns – creating long-term opportunities in Japan. “For example, Japan’s population has been aging for many years. That has propelled efforts to adopt automation to boost productivity.”
There are undoubtedly still opportunities in Japan, with the recent rally leaving many areas untouched. It is possible that the rally will trickle down, but the direction of the yen and interest rates is a potential curve ball to which investors need to be alert.
This story first appeared on our sister publication, Portfolio Adviser.
