The Japanese market has outperformed the global market in local currency terms over the past 2 years (see chart below).
For the record, it was only very recently that the Nikkei 225, excluding dividends, returned to its all-time high of December 1989. It should also be remembered that periods of outperformance by the Japanese market over the last 35 years can be fairly long, and that the outperformance can be substantial (see chart below).
In common currency terms (see 1st chart), the Topix only slightly outperforms the Stoxx600 and is in line with the S&P500 and the MSCI World. Unlike in 2006 or 2012-2026, the Topix is not clearly outperforming in common currency terms.
This is because most of the Topix’s performance was linked to the fall in the yen, which acted as a bullish engine for EPS in absolute and relative terms. In fact, the performance of the Japanese equity market (in local currency) has historically been linked to the weak yen (see charts below).
The yen is now close to its lowest level against the dollar since the late 1990s. The fall in the yen has been amplified by the deterioration in Japan’s current account surplus (higher import costs due to rising energy prices) and the deterioration in the government’s fiscal position. But since the start of 2022, the fall in the yen has above all reflected the divergence in monetary policy between the BoJ and the Fed: the BoJ is pursuing a monetary policy that is clearly more accommodative than that of other countries in the developed world. Japan is the only major developed country to have maintained negative real long-term rates. The dollar/yen exchange rate is highly sensitive to the real long-term interest rate differential between the USA and Japan (see chart below).
Japanese monetary policy has so far been fairly complacent about the resurgence of inflationary pressures. This is because the Japanese central bank is even more constrained than in the United States or Europe. Debt levels (public and private excluding financial institutions) are well above (406% by mid-2023) US and European standards (266% in the US and 255% in France). And we know that Japanese insurance companies and banks hold a lot of bonds (10-15%).
On 19 March, the BoJ announced a change in its monetary policy. It stopped its Yield Curve Control policy (steering 10-year rates at 0%) and reverted to steering short rates (Unsecured Overnight Call Rate) within a range of 0 to 0.1% (vs -0.1% previously). This is the 1st rate hike since 2007. It has stopped buying ETFs and JREITs. It will also gradually reduce its purchases of commercial paper and corporate bonds.
However, the BoJ will continue to buy JGBs in amounts similar to / slightly lower than the current amounts.
And it has not set itself any specific targets for reducing its balance sheet. It is leaving itself the option of countering any untimely rise in long-term rates by resuming purchases of JGBs if necessary.
Above all, Governor Ueda held a very accommodating press conference in which he reiterated his commitment to gradualism and indicated that he did not believe in a rapid rise in rates at the current time.
He also stressed the importance of keeping monetary policy flexible. It should also be noted that the decision to raise rates was not unanimous, with 2 dissenting votes out of 9.
Our feeling is that Ueda has been too cautious since his appointment last spring and that he probably missed the window of opportunity that was open to him last year. Activity has since slowed markedly (especially in industry) and inflationary pressures are easing (consumer prices, wages, expectations). The BoJ’s rate hike, against the rest of the world, should therefore only be modest and is unlikely to destabilise the markets (FX, bonds, equities).
What about equity market valuations? Despite the recent rerating (PE 12m fwd up from 12x at the start of 2022 to 14.4x today), valuations remain reasonable at first glance. The discount to the MSCI ACWI is around 15%. On the other hand, the Topix is now expensive compared with the Stoxx600 (a 15% premium, whereas the valuation is equivalent in the long term); see chart below.
EPS momentum is very good, with respectable sales growth and higher margins. It is outperforming most developed markets. What’s more, EPS expectations do not appear excessive: +14% for fiscal 2024 and +8% for 2025 (see chart below).
But beyond macro-economic and macro-financial factors, there are structural factors that are making the Japanese market more attractive. Firstly, improvements in corporate governance. In 2023, there was renewed pressure from the TSE (Tokyo Stock Exchange) to increase the creation of shareholder value (assessment of the company’s cost of capital and capital efficiency, particularly for companies that have always been listed below their book value). Generally speaking, all contemporary reforms aimed at improving value creation have not been in vain. There has even been a retreat from the „crony capitalism“ that has long characterised the Japanese system: fewer cross-shareholdings, an increase in the number of independent directors, greater transparency of accounts, etc.
This is borne out by the fact that Japanese companies‘ EBITDA margins have been catching up with those of their American and European counterparts over the last ten years or so, and by the upward trend in share buybacks and dividend yields (see charts below).
There is also a theme that has encouraged a rerating of the Japanese market in recent years: the end of the deflationary cycle in which the country has been mired since the mid-1990s. Unlike other countries, inflation is welcome in Japan. Today, actual inflation and inflation expectations (particularly among companies) have started to rise again, although they remain reasonable (see charts below).
All this while preserving margins, through a slightly downward adjustment in real wages despite a rise in nominal wages. All this explains the increased interest in the Japanese equity market on the part of foreign investors, as evidenced by the improved flow dynamics. There were 5 trillion yen of inflows last year.
But there is still plenty of potential, given what happened during the long rallies mentioned above (15 trillion in 2003-06 under Koizumi and 25 trillion under Abe in 2012-16).
It has to be said that the low level of Japanese interest rates is encouraging foreign investors (particularly US investors) to hedge their currency investments. The current short-term interest rate differential guarantees a return of over 5% on an annualised basis for American investors. In a value approach to equity markets (as advocated by W. Buffett, for example), both dividends and share buybacks need to be taken into account. The level of dividend yield is much higher in Japan (than in the United States, as we saw above), but the buyback yield is much higher in the United States (3% on average over 15 years, compared with 1% in Japan). All things considered, the total yield differential (dividend + buybacks) has nevertheless narrowed in Japan’s favour over the past 15 years. With currency hedging, this differential is ultimately more favourable to the Japanese equity market than to the US market.
It should also be remembered that Japanese households have considerable potential to invest in equities: more than half of Japanese household savings are invested in cash. This might have been conceivable in a world without inflation, but it is becoming much less relevant today.
In short, the Japanese market remains attractive, with a special mention for banking stocks in a likely scenario of slightly rising Japanese nominal rates and a steepening yield curve favourable to banks‘ net interest margins (see charts below).
