Japan’s first new high since 1989

Japan’s Nikkei 225 index has struggled over the past 34 years to reach its previous market peak set in December 1989. In the 1980s, cheap credit and excessive speculation led to a frenzied bubble, catapulting Japan to 37.5% of the world’s equity market capitalisation. Today, Japan accounts for less than 7%. Back then 15 of the world’s 20 biggest companies by market capitalisation, were Japanese and 6 of the world’s 10 richest people were Japanese. Now only 3 are ranked among the world’s top 100 billionaires. Recently, equity market performance has been picking up. The Nikkei gained 28% in 2023 and is already up by 16% since the start of 2024. Foreign investors are taking notice, sentiment towards Japanese equities is extremely strong. Those not invested could be forgiven for suffering the early onset of FOMO. Why is the market surging and is it sustainable?

Japan has traditionally been a very cyclical market, rising and declining with the ebb and flow of the global trade cycle. Early signals such as export figures from Korea and Taiwan and economic activity in Singapore together indicate improving global trade, which is beneficial for Japanese earnings. There are also structural longer-lasting reasons for the re-rating in Japanese equities. It appears that the country is finally waking up from its decades long struggle with deflation, which has been crippling for credit growth, investment outlays and consumer spending.

Consumer price inflation (CPI) has remained above the Bank of Japan’s (BOJ) 2% inflation target for over 2 years, and rising wage growth suggests positive inflation will be sustainable. Although much depends on the outcome of the annual Shunto wage negotiations between companies and unions, BOJ policy member Junko Nakagawa recently stated that “There is a clear change in stance in companies’ wage-setting.” The BOJ is increasingly confident that deflation has been beaten and is expected to finally make a start with exiting negative interest rates at its upcoming policy meeting on 19th March.

Perhaps more significantly, the shift in structural reforms, corporate restructuring and improved corporate governance is gaining momentum, to the benefit of profit margins and shareholder returns. The Japanese corporate landscape used to be dominated by the “keiretsu” system with intricate cross-shareholdings among companies making it difficult for shareholders to exert influence or challenge management decisions. The system created stability but hindered corporate governance practices and the efficient allocation of capital. Weak profit growth and bloated balance sheets which often ensued caused many Japanese companies to trade at price-to-book ratios of below 1. In other words, they would be worth more if they were broken up and sold. The shift towards unlocking these discounts may be hitting a tipping point as companies are Japanese companies are increasingly prioritising shareholders over other traditional stakeholders. 

Japanese companies are increasingly recognising the opportunities for value creation through higher dividend payouts, share buybacks, more efficient allocation of capital, the sale of non-core assets and the sale of crossholdings. JPX, the group controlling the Tokyo Stock Exchange announced in December new rules which oblige companies persistently trading below book value to disclose plans to remedy that situation. Seth Fischer, chief investment officer at activist fund manager Oasis said “The value trap that is Japan is no longer… What was a market full of companies continuing to hoard capital and happy with their market share has become one where management, for a whole host of reasons, is now focused on increasing profitability and shareholder return.”

The sharp rise in Japanese equities over the past 12 months has been equally spread across market sectors. Broad based participation in the bull market is illustrated by similar performance in both the equal weighted index and the overall aggregate, suggesting the rally is on a sound footing. Independent research firm MRB Partners reports that industrials, consumer discretionary, technology and financials, the four largest sectors of the market which together make up a combined 70% of total market capitalisation, are all in solid uptrends. Valuations are cheap despite the recent advance. Despite rising profit margins and returns on equity, the industrial sector is trading at a 12- month estimated forward price-earnings multiple of 15x, in line with the median of the past two decades, the consumer discretionary sector is trading on a 12x PE below its two-decade median, while technology is on a 23x PE which is higher than the median but cheap compared to the world’s other technology markets. Financials trade on a 10x PE and a 20% discount to book value, cheap due to the chronic low interest rate environment but net interest margins should benefit as the BOJ starts to normalise interest rates. Overall, Japanese equities trade at a moderate discount to the global benchmark on a forward PE basis, and even more strikingly undervalued on a price-book basis, at a 50% discount.

Currently, foreign investors favour Japanese equity markets above all others from a purely sentiment perspective. Japanese investors are not yet persuaded despite the government’s incentives. For most households, the memory of the steep post 1989 decline and the lost decades of deflationary performance remain too raw. Some analysts including Bruce Kirk, chief Japan equity strategist at Goldman Sachs believe the market’s recent breakout above the 1989 peak achieved on 22nd February will provide a strong psychological boost for domestic investors. “It’s an incredibly important barrier for Japan to have finally broken through.”

Japanese households are sitting on a massive savings stockpile of $7.7 trillion, which if partly shifted to equity markets could provide a significant lift to performance. In January this year, the government raised the limit on tax free contributions to the Nippon Individual Savings Account scheme, from ¥1.2 million to ¥3.6 million for annual contributions while the cumulative limit was raised from ¥6 million to ¥18 million. Only 13% of Japan’s liquid household assets are invested in equities compared with 40% in the US and 21% in Europe. In the words of MRB, the BOJ’s expected exit from negative interest rates “should reinforce in investor eyes that the deflation era has passed, and more “normal” economic conditions are developing”, paving the way for further market gains.