Of all major equity indices, the Nasdaq has posted the best year-to-date return at 23.5% but the US country-wide benchmark, the S&P 500, has returned a lower 8.2%. It may surprise some, as Japan has been off most investors’ radars over the past two decades of deflation, that the Nikkei 225 has been the best performing developed market index YTD, with a 16% return. Japan’s economy is benefitting from a relatively recent Covid reopening and close trade ties with China, which is rebounding from last year’s steep decline. Japan’s economy has emerged from its decades-long deflationary spiral. Wages are seen as the key to lasting inflation and the spring wage negotiations concluded a 2.14% base pay increase, up from 0.62% last year. Two of the country’s industrial giants, Toyota and Honda, agreed to 5% wage increases.

Despite the economy escaping recession and inflation’s welcome return, the Bank of Japan is sticking to negative interest rates and an asset purchase programme to cap the 10-year government bond yield at 0.5%. The BOJ is alone in the world, in providing generous monetary policy accommodation, but economists are predicting a shift.

The BOJ’s new governor, Kazuo Ueda presided over his first policy meeting in April. He is the first academic at the post, chosen to normalise monetary policy following his predecessor, Haruhiko Kuroda’s massive 10-year stimulus. Under Kuroda, the BOJ expanded its balance sheet to 120% of GDP. Through its asset purchase programmes and defence of its bond yield cap, it now owns 54% of all outstanding government bonds and half of domestically listed exchange trades funds. As a result, the bond market is no longer functioning as it should. Liquidity has dried up and much needed bond collateral is scarce.

It is widely expected that under Ueda, the BOJ will aim to restore the bond market’s key functions by adjusting the bond yield cap and possibly removing it altogether. At the same time, the key interest rate is likely to rise from minus 0.1%. Consumer price inflation is expected to hit 4.5% by mid-year well above the BOJ’s 2% target. At his first policy meeting, Ueda said, “Compared to before, we’re now able to have some hope that the 2 per cent inflation target can be sustainably reached.” The accompany policy statement also dropped its long standing forward guidance that the BOJ “expects short- and long-term policy interest rates to remain at their present or lower levels.” Ueda is clearly laying the groundwork for a monetary policy pivot.

There will be financial market ramifications. Asset prices will need to adjust to higher bond yields, bank balance sheets may unravel in response to falling bond prices much as they did during the US mini banking crisis in March. Homeowners will need to adjust to rising mortgage interest rates. However, Japan’s banks are in good shape, far better than most and Japan’s household debt is low. The country has not had a property boom or credit boom since the early 1990s. The global impact of Japan’s monetary policy normalisation is likely to be greater than the local impact. Rising short- and long-term Japanese interest rates will choke off the lucrative “yen carry trade”, whereby debt is raised in yen at low interest rates and invested at higher rates in other countries. Global yen denominated debt may no longer be a key source of global liquidity. At the same time, Japanese institutions will increasingly repatriate their offshore funds. The result is that the yen will strengthen.

An end to the BOJ’s so-called “Yield Curve Control” (YCC) has been cited by some investment strategists as a key risk to global financial markets. Yet, global markets are likely to suffer more than Japan’s. The yen’s ensuing appreciation will help amplify Japanese investment returns. Warren Buffett, a recent advocate of Japanese investing remains undeterred. Having had little interest in Japanese investment for most of his illustrious career, Buffett has invested significant amounts since 2020, steadily accumulating strategic stakes in Japan’s five biggest trading houses. He has amassed a 7.4% stake in each of Mitsui, Mitsubishi, Sumitomo, Marubeni and Itochu. He funded his purchases through yen debt and is reportedly planning another debt issue, raising speculation that an additional Japanese acquisition is in his sights.

Buffett is known for his “value” investing style. Besides Japan’s success in defeating deflation, he must be drawn to the extremely cheap valuations on offer. The five trading houses trade at sub 10x price earnings multiples and close to 5% dividend yields, but the whole market is ridiculously cheap. The Nikkei trades at an estimated forward PE ratio of 12.8x compared with a long-term average of 24x and a price-to-book of 1.28x compared with a long-term average of 1.34x. The dividend yield is 2.53% compared with a long-term average of 1.34%. Valuations are compellingly cheaper versus global averages and their cheapest versus the US markets in 50 years.

Overberg Asset Management has substantial exposure to Japanese assets in its global private share portfolios, drawn by the country’s steadily improving corporate governance and greater board emphasis on shareholder returns. As the country wakes up from its long deflation induced hibernation, economic activity and corporate earnings are likely to expand at well above the long-term average pace, delivering improving returns for investors. The end of YCC and its implications for yen appreciation could add to Japan’s expected equity market outperformance.