Japan Stands Out From Developed Pack

Transcript

Japan is starting to look different from other developed markets. And investors are taking notice.

We have been underweight developed market stocks. For Japan, we were concerned about risks tied to the Bank of Japan scrapping its cap on government bond yields.

But Japan stands out to us now, and here’s why:

1) A brighter economic backdrop

After decades of deflation, nominal growth seems to be positive and is likely to stay so. We think the BoJ will be slow to tighten policy, even if it alters its yield cap.

Why? Japan is committed to dispelling the deflationary mindset. So interest rates will likely stay negative for at least another year.

2) Corporate reforms

Japanese authorities have recently put more pressure on corporates to deploy their ample cash. This is significant and may be a dawn for shareholders after 3 decades of disappointment. We look for more evidence in coming weeks as thousands of corporates host their Annual General Meetings.

3) Growing investment interest

Foreign investment in Japanese stocks has surged since April. But we shouldn’t forget this follows years of very large outflows, and we see more room to run as investors gain confidence in Japan’s still-nascent performance.

We think a better policy picture and reforms could make Japanese equities more attractive, and we think the effects are likely to be felt for quarters and even years ahead.

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We see the outlook brightening for Japanese stocks and are rethinking our modest underweight that is currently in line with other DMs. We initially saw risks if the Bank of Japan (BOJ) scrapped its cap on government bond yields to curb inflation. We now believe inflation is unlikely to stick due to fewer supply constraints. So, the BOJ may opt to keep policy loose to sustain above-target inflation. Plus, corporate reforms are spurring a shareholder-friendly shift – a key development this year.

Renewed interest

Notes: The chart shows cumulative net weekly flows into Japanese equities by foreign investors since the start of 2012.

We’ve seen some investors get excited about foreign investment in Japanese stocks surging since April (see the dark orange line in chart), a reversal from the lackluster interest of recent years. There have also been questions about whether enthusiasm may be overdone. We believe assessing the change calls for a longer-term perspective – looking back more than a decade ago when then Prime Minister Shinzo Abe introduced his “three arrow” approach to structural economic reform. Investment in Japanese equities began to slide in late 2015 as the initial euphoria over monetary policy, fiscal policy and corporate reforms faded – especially as the corporate reforms took time to pan out. Global investor interest has picked up in recent weeks, but the uptick does not come close to offsetting the outflows since 2015. What’s reviving foreign investor interest? A more shareholder-friendly approach by Japan’s companies and loose monetary policy not unwinding quickly.

Case in point: The Tokyo Stock Exchange has asked companies that are trading under their book value to publish plans “as soon as possible” on lifting their stock prices. The exchange specifically called for better balance sheet management as many companies hoarded cash over the past decade. We think it makes sense for companies to deploy this cash by investing in growth opportunities or buying back shares now that the growth outlook has improved and inflation has returned. We see this as a potentially pivotal moment for Japan: Roughly half of its companies trade below book value and roughly half have cash on their balance sheets after subtracting liabilities, Refinitiv data shows. Signs companies are complying may appear in coming weeks during Japan’s annual shareholder meeting season. Plus, Japanese investors could be the next key buyers, thanks to tax incentives starting in January 2024 that encourage savers to shift their money from cash into investments.

Japan’s policy picture

On the macro front, the BOJ’s efforts to raise inflation – after a long battle with deflation – are a stark difference from other DM central banks that are still hiking rates to deal with stubborn inflation. We thought the BOJ would be forced to scrap its yield cap and quickly tighten monetary policy because inflation surged above its 2% target. We saw risks that getting rid of the cap would push up global yields and reduce risk appetite. That’s why we went underweight Japanese stocks in February on our tactical horizon of six to 12 months, in line with our underweight to other DM stocks. Yet, now we think the BOJ will be slow to tighten monetary policy, even if it alters its yield cap as it has signaled it will in coming months.

Why? Japan’s inflation has picked up sharply, partly due to the energy crunch as the West tried to wean itself off of Russian supplies. The impact did not hit Japan’s economy as hard as Europe and has since faded as energy prices fell, reducing the drag on incomes. Import prices have also started to cool. Other inflation drivers are easing too: wage gains have fizzled since the end of 2022. Japan’s labor market does not face the same constraints as in other DMs, and has room to grow without stoking inflation. We see the BOJ being more cautious in tightening policy to ensure inflation has become embedded.

Bottom line

The BOJ likely winding down its ultra-loose policy slowly and corporate reforms differentiate Japan’s stocks from DM peers, we think, even as we stay cautious on DMs overall. We see higher inflation spurring households to search for better returns instead of hoarding cash, especially as incentives for stock investment are rolled out. Japanese investors may bring money back home if bond yields rise with changes to the BOJ’s yield cap. We think foreign investors could consider unhedged Japanese equity exposures to benefit from any yen strength. We see the BOJ intervening again if the yen weakens too much.

Market backdrop

DM short-term bond yields rose last week even as equities lost some steam. The Bank of England raised rates by more than the market expected, pinning the two-year gilt yield near 15-year highs. The Swiss and Norwegian central banks also hiked. We think central banks are being compelled to hold policy tight as inflation remains persistent. We see a tighter policy era ahead – and expect that to reinforce the new regime of greater macro and market volatility.

We’re gauging U.S. consumer spending and inflation in the PCE data out this week. Euro area inflation is also in focus. We see major central banks keeping interest rates higher for longer to fight sticky inflation driven by supply constraints. We expect core inflation to stay above policy targets for some time.