Market Views: Can soaring Japanese equities go even higher?
Japan’s benchmark Nikkei 225 index closed at a three-decade high on June 2 while another stock market index, the Topix, also soared to a new high not seen since July 1990.
AsianInvestor asked asset managers about the outlook for equities and what data points, events and fundamentals investors should watch.
The following contributions have been edited for clarity and brevity.
Michiko Sakai, portfolio manager for Japan equities
J.P. Morgan Asset Management
Japanese equities are unloved, under-owned and undervalued. We see many improvements from a bottom-up and top-down perspective which makes us optimistic about this market.
First, we are still in the preliminary stages of a multi-year trend in corporate governance improvement.
This started several years ago but momentum has recently stepped up with the Tokyo Stock Exchange (TSE) pressuring companies with a price-to-book ratio (PBR) of under 1x to come up with specific initiatives for improvement.
We see a wide range of companies committed to change, among which over 50% of companies are trading below PBR 1x and more than 50% of non-financial companies have a net cash position, and we expect more to come.
May saw the largest ever number of companies conducting a share buyback, and some cited the TSE guidance as a reason for decision.
Meanwhile, Japan is probably ending deflation.
Inflation, whilst modest by global standards, is at the highest level in decades. Wages are increasing at many companies, and this is positive for the economy.
These come at a time when the market trades on a low valuation on both a price-to-earnings ratio (PER) and PBR basis, but we think this market remains under-owned by foreign investors.
Kensuke Niihara, chief investment officer, Japan
State Street Global Advisors
Both cyclical and structural trends have been supporting the Japanese market.
Cyclically, late re-openings in Japan are supporting economic recovery relative to US.
Several structural trends also make the Japanese market attractive to foreign investors, such as the increasing expectations of inflation and ongoing increase in prices of goods, Tokyo Stock Exchange’s reform for higher capital efficiency and supply chains diversification away from China.
Lack of immediate policy change at the Bank of Japan is supportive of weaker yen and positive for equities.
Valuations are still relatively attractive, and we believe long-term foreign investors have capacity to allocate more to Japanese equities when corporate governance improves, and capital efficiency is realised.
Overall, it is reasonable to expect further upside after the recent rally.
However, we should keep an eye on a few data or events such as whether the improvement in capital efficiency can be sustained.
If there is little change, the market could be disappointed as it has been a few times in the past. A US slowdown and the Fed easing more than discounted could trigger US dollar weakness and yen strength, which could limit further upside of the Japanese equity market.
Daniela Gombert, portfolio manager global equities
DWS
The Nikkei had a total return of 26% year to date (in yen) and reached almost a similar index level as in 1989-1990.
However, valuation levels today are more in-line with the broader market compared to three decades ago.
We expect that Japan’s reopening, the return of tourists to the country and China’s recovery to continue to support Japan’s private consumption in 2023.
The weakness of the yen could further support earnings and export-oriented companies, although a reversal of the yen weakness and weaker global demand could pose headwinds to Japanese exporters.
However, with headline inflation most likely beyond its peak, this might ease the pressure for the Bank of Japan to tighten its monetary policy.
A global recovery on the back of 2023 could benefit cyclical companies in Japan.
Additionally, Japanese companies could also be a beneficiary of the de-risking of global supply chains given their strength in certain verticals, such as in factory automation.
Overall, Japan equities provide an opportunity for investors to participate in the Asian growth theme.
John Vail, chief global strategist
Nikko Asset Management
This year, the broader Topix index has slightly underperformed the S&P500 in US dollar terms due to yen weakness.
The Nikkei 225 index, however, outperformed the S&P500 on this basis because some of its highly weighted stocks surged.
Given intense global interest in Japan recently, it is surprising that Japan equities have not greatly outperformed.
Both foreign and local investors are finally realising that the valuation discount in Japan was too large, and the country faces much fewer macro and political headwinds than other countries.
Investors seem to prefer Japanese over PRC (People’s Republic of China) equities as conditions there are less attractive in many respects.
Even some PRC investors supposedly are now keenly buying Japanese equities.
Valuations have risen slightly recently, but not narrowed much versus the US, thus, there are strong reasons to assume that interest in Japan will persist. Japanese corporations profit guidance is usually very conservative, but during the fiscal year, it should become more realistic, so quarterly announcements and updated guidance are key.
Although the Bank of Japan will not likely become hawkish soon, investors should watch its announcements.
Perhaps the greatest concern is global macro events, especially in the US and China. If there is any tilt towards harder landings there, Japanese corporate profit prospects and equity valuations would deteriorate.
Dan Carter, fund manager
Jupiter Asset Management
Japan remains a poorly understood market and has wonderful companies available at big discounts to their global peers.
But there are decidedly ropey businesses too, where lack of creative destruction has allowed too many unprofitable businesses, stuck in reverse, to survive.
The good news is that the Japanese economic and financial establishment appears to have had enough.
The latest round of public flogging, following the Ito Review and the establishment of Governance and Stewardship Codes in the last decade, is being led by the Tokyo Stock Exchange.
Early signs are that their campaign to get corporate Japan to help itself is having some success.
We are delighted and believe that a number of our investments can and will boost returns through better management of capital, and their own operations.
There is a risk that the focus on capital management distracts from the pressing need for operational reform – a business with no or negative growth and thin margins is a poor company and likely a poor investment in the long term no matter how smartly the balance sheet is rearranged.
That Japanese return on equity lags its international peers is as much an issue of sub-par profit margins as it is bloated balance sheets. We like capital efficient companies, but we love businesses which are becoming structurally more profitable.
We are wary of any premature euphoria. It would be an error to be intoxicated by the fear of missing out and to loosen selection criteria in hope of a big short-term win. Not all companies that could change will.
Daniel Hurley, portfolio specialist for Japanese equity strategy
T. Rowe Price
We believe the country's recovery is still in its early stages and the Japan story will continue to gain momentum over the long run.
Sustainable inflation, strength of the yen, improving corporate governance and the potential of a US recession are key factors to watch.
Signs of a sustainable return of inflation in Japan is extremely encouraging and a huge boost for investor and business sentiment.
As inflation has ticked higher in Japan, wage hikes have started to come through, which should be very supportive for the consumer and domestic consumption.
These wages have been primarily in the large cap sectors for now, we believe mid and small caps will follow their lead.
The increasing inflation is also forcing Japan’s corporates to question the excess cash on their balance sheets as the time value is eroded away.
With that, Japanese corporates buying back stock and returning capital to shareholders at record levels.
As corporate governance reforms continue to make headway, we expect to see higher returns on capital, a positive sign from companies and signals their improving governance.
Furthermore, long term secular trends like growth in factory automation, use of robotics, and vehicle electrification are supportive of many Japanese industries.
Although a potential US recession in the second half of 2023 would challenge Japanese equities due to the export-oriented economy, much risk is already reflected in company valuations.
This creates opportunities for bottom-up, fundamental investors to find quality businesses at reasonable prices.
David Chao, global market strategist, Asia Pacific (ex-Japan)
Invesco
Japanese stocks have enjoyed momentum lately in what seems to be a perfect storm, driving a rally in the Nikkei and Topix indexes.
Because Japan reopened from COVID-19 much later than other developed economies, domestic spending is only at its nascent stage and personal consumption is accelerating due to fiscal stimulus and inflation multi-decade high inflation.
Japanese corporate earnings should improve in the coming year, based on both fundamentals and considering the yen’s collapse against the US dollar early last year which supports Japanese multi-national corporations with large overseas operations.
The Tokyo Stock Exchange is also implementing structural changes to help boost company valuations – a significant portion of the Japanese market is trading below book value and sustained valuation expansion could bring even more domestic and foreign investors back into the market.
Despite the demographic decline in Japan over the past few decades, the economy has been able to grow through efficiency and productivity gains coupled with overseas investment and trade.
Longer term, a rising China, Indonesia, India and Vietnam present significant capital and infrastructure investment opportunities for Japanese corporates already active there.
I can’t think of any other developed economy that has so many regional greenfield opportunities at its doorstep.
The biggest risk could come from the Bank of Japan abandoning yield curve control, which has become increasingly unsustainable facing rising interest rates globally.
Extreme yen weakness may force the Bank of Japan’s hand in unwinding its ultra-loose monetary policy, but Japanese equities can remain resilient through this normalisation given the encouraging domestic dynamics.