After over three decades of sluggish inflation and battered company valuations, Japan looks anticipatorily at an imminent recovery. The country’s Tokyo Stock Price Index (TOPIX) finally saw a semblance of its heydays by rallying to its highest level in 33 years. Japanese equities performed spectacularly in 2023 as TOPIX and Nikkei 225 returned 22% and 31% on a year-to-date basis respectively. This compares against the S&P500’s 15% and Stoxx 600’s 7% during the same period.
Warren Buffett’s Berkshire Hathaway has also continued to boost its investments in Japan, further fueling the impressive surge in the country’s stock market. Berkshire Hathaway announced on Monday that its average stakes in Itochu (ITOCF), Marubeni (MARUY), Mitsubishi Corp, Mitsui & Co (MITSY), and Sumitomo now exceed 8.5%. Buffett’s investments in Japan, coupled with his optimistic outlook for the country’s future, have brought attention to the improving economic conditions and the implementation of shareholder-friendly corporate governance reforms.
In the past, investors watched the Japanese stock market rallies fizzled, as their hopes for a sustained bullish run were quashed time and again by wary investors left embittered by the 1990 bubble burst. This time however, many pundits stay convicted that there is more upside left to be realized due to cheap valuations. Both camps furnish compelling arguments in support of their case. In this article, we consider the reasons fuelling the recent resurgence and analyse if the land of the rising sun can finally reclaim its seat in the sky.
The bull case
Thesis 1: Macroeconomic recovery driven by consumer spending
First quarter economic data positively surprised the market as Japan emerged from recession. Nominal gross domestic product (GDP) comprises private consumption, investment, and exports. The first component constitutes over half of the economy, buoyed by reopening due to pandemic boosted service spending. Wages also rose by the largest margin in 30 years as labour unions scored victories during the 2023 shuntō negotiations. Furthermore, capital expenditure also beat forecasts by registering a 0.9% expansion against a projected 0.4% fall.
TOPIX responded to the encouraging set of results by rising 0.4%, while Nikkei inched 0.8% higher. On balance, the remarkable first quarter data was weighed down by weaker exports as overseas growth falter. Nonetheless, persistent inflationary pressures augurs the country’s escape from its long-term recession widely known as the “Lost Decade”.
Thesis 2: Trade diversification due to tensions
Amid the intensification of trade tensions between the US and China, G7 leaders jointly agreed towards de-risking and diversification away from China by exploring other trade partners. Southeast Asian countries (SEA) such as Malaysia, Thailand and in particular, Vietnam, are slated to be beneficiaries from the trade diversification. Yet, paradoxical issues such as increased economic dependence of SEA on China instead of the West surface. Moreover, SEA also demonstrated tepid interest in closer cooperation with U.S. by decoupling from China. This is where Japan comes into play. SEA perceives Japan as the most trustworthy country, making the latter a cardinal gateway for the West to achieve higher levels of supply chains integration within the region. Moreover, as one of the top countries with the broadest geographic reach of international flows and being closely situated to China, Japan positions itself as a strong candidate to become a core replacement hub for supply chains.
An industry which is eyeing Japan as an alternative destination to relocate its critical activities is semiconductors. Following a Chinese ban on products manufactured by America memory chipmaker, Micron Technology (NASDAQ: MU), Japan shored up financial incentives to support its semiconductor industry to encourage direct investments into the country. Fund managers are adding their exposure to Japanese chipmakers as they remain optimistic about the near-term fundamentals of these companies. In turn, domestic semiconductor companies propel the Nikkei index upwards despite weakness in certain sectors like financials.
Thesis 3: Shareholder activism and unlocking corporate value
TOPIX has historically lagged Western indexes such as S&P500 in terms of price-to-book ratios – a sign of dampened corporate value that punishes shareholders. Since then, the Japanese Exchange Group (JPX) implemented policies that promise greater capital efficiency and thus, shareholder returns. For instance, major names such as Toyota Motor (TYO: 7203), Mitsubishi UFJ Financial Group (TYO: 8306), and SoftBank Group (TYO: 9984) were demanded by the Tokyo Stock Exchange to come up with a concrete plan to boost their share price above book value. Another concrete example is the lifting of payout ratios by Japanese companies, boosting dividend yields of TOPIX above that of S&P 500.
Emboldened by regulatory pressures, shareholders are also clamping down on poor corporate governance. Rising shareholder activism is witnessed in the growing number of Japan-focused activist hedge funds over the past ten years which drove the number of shareholder proposals submitted by activists this year to increase by 60% year-on-year. Deep reforms of the Japanese equity markets to bolster investor confidence culminated in global names to flock towards Japan. Esteemed funds like Elliot Investment Management have indicated interest to expand coverage of Japan, while venerable investors such as Warren Buffett has increased Berkshire Hathaway’s holdings in Japanese companies. Basking in the limelight, it is no wonder Japanese stocks have enjoyed a great 2023.
The bear case
Antithesis 1: Inflation looks weak as real wages fall
Despite strong showings from first quarter results, Japan’s macroeconomic environment may falter in the latter part of the year. Consumption remains as a key driver to spur Japan’s recovery. Unfortunately, successful shuntō negotiations only resulted in nominal wages to hike while real wage growth remain in negative territory. Nominal cash earnings have also only increased by 1.0%, falling short of economists’ estimates and far below the suggested 3.0% necessary for sustainable inflation, according to Bank of Japan (BOJ) officials.
Couple this with an ageing demographic plagued by a declining birth rate, fewer people entering the workforce means lower spending and thus stagnant prices. Japan has been locked in a battle against deflation for decades. The deeply ingrained deflationary mindset of Japanese consumers that inhibit consumption can easily be exacerbated by the uncertain wage outlook, trapping the third largest economy in the world in an inescapable deflationary cycle. This may shake investors’ beliefs in Japanese equities as reduced spending ultimately hurts not just the economy but also corporate profits.
Antithesis 2: Other countries benefit as trade diverts from China
Japan is not the only destination as capital moves away from China. Other Asian hubs such as South Korea, Taiwan, and India also saw their respective benchmarks edge higher due to foreign money inflow. Notably, none of these countries fall into the SEA region. Above, we mentioned how investments in the semiconductor market will benefit Japan. Yet, foreign investments into Taiwan and South Korea dwarf that of Japan, with the two markets collectively accounting for 64% of the region’s total inflows in May 2023. This is off the back of strong demand for chips supporting artificial intelligence (AI), an area that Taiwan and South Korea have significant exposures to. India is another strong contender for foreign money as a mix of the country’s comparatively young demographic alongside faster growth rates of macroeconomic indicators such as inflation and GDP lead to booming consumptions.
Back in Japan, the volatility of the Japanese yen may also plague corporate profits. If the yen rallies too strongly, companies heavily reliant on exports will be hit hard; on the other hand, yen weakness drives import prices upward and batters the highly important private consumption component that underpins the country’s economic health. All eyes will be on the relative rate movements between the Federal Reserve and the BOJ which can nudge the yen in either direction. Such uncertainties may prompt investors to reconsider before ploughing more funds into the Japanese market.
Antithesis 3: Domestic investors not sold by corporate reforms
Upsurge in Japanese equities are overwhelmingly due to the foreign capital inflows. Meanwhile, local investors are rushing for the exits by dumping Japanese stocks to enthusiastic outsiders. Haunted by ghoulish echoes of the burst bubble three decades ago, domestic investors are cautious of the gradually expensive index and prefer to take profit when markets are doing well. In fact, locals are betting against the recent gains by taking short positions in bear funds. Alarm bells should start to ring: Surely Japanese investors wield a more intimate understanding of the tides and taking contrarian stakes is a risky venture?
As it stands, there is good reason to be cautious. Market restructuring rules by the JPX have yet to demonstrate their effectiveness in overhauling the resistance of Japanese management to adopt shareholder proposals. Enforcement through strongarm tactics such as forced delisting of companies that fail to meet listing criteria such as investor engagement and capital efficiency is also unlikely. Entrenched interests and beliefs simply do not change easily. Furthermore, the identity of stakeholders driving corporate reforms cannot be neglected either. Companies may be more receptive to local instead of foreign activists pushing for governance changes. Yet, fund flows indicate greater foreign ownership and thus outside influence, sowing more doubt about the sustainability of reforms.
The fifth perspective
Make no mistake: Japan’s TOPIX and Nikkei 225 have outperformed almost all other countries’ indexes this year. There could definitely be room for Japanese equities to march higher. However, history suggests that Japan has its own unique set of circumstances that bound the country’s bourse in a ‘value trap’. Wagering against a history that spanned decades in hopes of achieving outsized returns must be supported by multiple, extremely compelling arguments. Even then, there is every chance that us non-native campaigners and shareholders are getting ahead of ourselves.
