What's behind Japan's surging stock market?

Cherry blossom season in Japan (or hanami) arrived late this year, as cold weather held off the full flowering until early April. Sakura (cherry blossom trees) bursting into life marks the start of Spring in Japan, a time of newness and freshness. Market watchers will have observed a similar blossoming of the Japanese equity market of late, though possibly with much greater surprise than the expected floral display.

Headlines rang out around the world announcing the Nikkei 225, Japan's main stock index, hit an all-time closing high, surpassing 40,000 and the previous record set 34 years ago in 1989*. The Nikkei 225 is up 15.5% year-to-date*, outshining developed market peers last month and in the first quarter of 2024, which it has lagged for decades.

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What is behind this sudden reversal in fortunes?

Part of the explanation can be seen in the fact the rally of Japanese stocks has been centred on large-caps (though not to the extent the US market has been concentrated on the ‘Magnificent Seven’) and that the Nikkei 225, which is more focused on exporters and tech companies, is at a three-year high relative to the broader TOPIX index**.

With that in mind, Daniel Hurley, portfolio specialist at T. Rowe Price, covering its Japanese Equity fund, points to the reasons for the sudden surge being three-fold – “a robust global economy and growth, supportive foreign exchange helping exporters, and corporate governance reforms boosting shareholder returns,” he says.

While these factors are undoubtedly important, they may be supporting just a contagious new realisation about the attractiveness of Japanese businesses. “The fundamental reason the Nikkei is strong is that foreign and domestic investors have discovered Japan’s excellent companies after too long of not paying attention, prompted by the extreme concentration of the US market and the geopolitical risk of investing in China,” says Richard Kaye, manager of the Comgest Growth Japan fund.

The Japanese technology industry, for example, has myriad companies indispensable to the global semiconductor supply chain, an opportunity to support the growth of Asia, and is part of domestic social changes which have been happening in the country for several years – “epochal themes” – that Richard expects to support Japanese equities’ revaluation.

Is the recent surge sustainable?

From its 22 March peak, the Nikkei 225 has been a bit choppy and on a downward trend, dropping 6% to date*.

Richard Kaye believes 45,000 – 10% higher – is arithmetically justifiable for the Nikkei using an average developed market valuation and Japanese aggregate earnings. But only if the market’s leadership stocks deviate from the themes of corporate governance change and inflation, to areas such as technology leadership, growth of Asia and social change.

Goldman Sachs research expects the TOPIX to reach 2,900 over the next 12 months (up from its previous 12-month forecast of 2,650), with a forecast cumulative growth in earnings-per-share of 32% over the next three years***.

Carl Vine, co-head of Asia Pacific Equities at M&G, which includes its Japan fund, believes Japanese equities represent a “compelling” long-term opportunity in a global context. “We continue to believe structural earnings growth, principally derived from corporate self-help, will be a strong driver of market returns,” he says.

Taking into consideration a strong dividend and buyback story in Japan, it’s not unrealistic to expect the Japanese equity asset class to deliver a mid-teen total compound return in the decade ahead, even without an uplift in valuations, Carl says. “Compared to the underlying risk of ownership, this feels attractive to us”, he adds.

Are there any concerns for investors?

Such a period of strong performance, however, has raised investor jitters. There is also investor concern about rising wages, which could have a big impact on Bank of Japan (BoJ) policy over the coming months, with some commentators forecasting another rate rise. This is after the BoJ judged in March its target of 2% sustained and stable inflation was "in sight" and so momentously voted to end its negative interest rate policy.

A weakening Yen is another potential issue. “Apart from the earnings sensitivity of the currency for companies, there is also the issue of imported price inflation as the Yen weakens further. The only meaningful tool Japan has to address the currency weakness is to raise interest rates further,” says John Paul Temperley, manager of the AXA Framlington Japan fund.

This could add to stock market volatility and change which companies lead the main indexes. “Luckily, we run a core-type approach which is focussed on valuations. We see this as an opportunity as much as a risk,” says John Paul. He is still seeing significant opportunities among Japanese companies. “The great thing about the Japanese equity market is that it has excellent companies across a diverse range of sectors,” he points out.

Kikkoman for soy sauce, Asics for running shoes, Shin-Etsu for fine chemicals, Toyota for cars, Tokyo Electron for semiconductor equipment, are all good examples^. And not forgetting Japanese banks and real estate companies that are looking cheap historically. “The challenge is more about fitting them all into a portfolio. We don’t have just Seven Samurai, more like a platoon of 100!” says John Paul Temperley.

With so many high-quality Japanese companies to choose from, there is plenty to play for amid the new enthusiasm among investors driving, and being driven by, the turbocharging of the Nikkei 225 so far this year. There is a sense we are seeing the tide finally turn for Japan.

“Until last year, the change of mentality around pursuing profitability went largely unnoticed by investors – but the opportunity was hiding in plain sight,” says M&G’s Carl Vine. The present excitement about Japan suggests investors are now understanding what is happening. But he thinks there is further to go.

He says: “We suspect that the full extent of the changes that have taken place and the potential growth that could be achieved in the coming years are still not fully appreciated.”

*Source: Google Finance, as at 24 April 2024
**Source: T. Rowe Price, April 2024
***Source: Goldman Sachs, 7 March 2024
^Source: AXA Investment Managers, April 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 24/04/2024