No, we do not think it is likely that Japanese equities can meaningfully outperform in the near term, given growing headwinds from the slowing global manufacturing cycle, possible monetary tightening, and potential Japanese yen (JPY) strength. Still, we do not think investors should be intentionally underweight, as Japan may continue to benefit from structural changes in global supply chains and geopolitics. We prefer strategies, such as buyouts and activist managers, that will benefit from increased corporate focus on shareholder return and are less reliant on broad market beta.
Japan is back on investors’ radars as the market has performed quite well this year, with the MSCI Japan Index returning 25.4% in local currency terms versus 17.6% for the MSCI All Country World Index (ACWI). 1 However, this outperformance is somewhat of an illusion, as weakness in the JPY has resulted in Japanese equities actually underperforming in USD terms (16.4% versus 18.1%). Indeed, the roughly 20% decline in the JPY since the end of 2021 means Japanese equities have returned essentially the same as the MSCI ACWI (-3.0% versus -3.6%) over the past 19 months for unhedged investors in contrast to the 19.7% return in JPY terms. 2
The resilience of Japanese equities is due, in part, to the fact that the Bank of Japan (BOJ) has not meaningfully tightened monetary policy in response to rising inflation, keeping interest rates low, while rates have risen dramatically elsewhere. This in turn has led to the sharp decline in the JPY, which has boosted the overseas earnings of Japanese companies, as well as their export orders. Indeed, Japanese second quarter 2023 real GDP growth beat expectations by a wide margin on the back of surging exports.
However, this dynamic may start to change, given the need to tighten monetary policy in the face of high inflation that is actually weakening domestic demand (both private consumption and imports contracted in the second quarter). In July, the BOJ surprised markets by widening the upper limit of its “yield curve control” cap on ten-year Japanese government bonds to 1.0%, although the benchmark policy rate was kept at -0.10%, the last major central bank to maintain negative interest rates. With one measure of core inflation in Japan at 4.1% (a 40-year+ high) and inflation expectations rising, the need for additional monetary tightening may send the JPY higher and take the steam out of the Japanese equity rally. This is especially the case if other central banks are at the end of their tightening cycle, let alone if they begin to cut rates due to a global slowdown.
At the same time, equity valuations in Japan are not as “cheap” as often assumed. Relative to their post-bubble history since 1991, Japanese equities are actually at the 87th percentile on a normalized price-to–cash earnings basis, while more traditional metrics such as forward price-earnings and price-to-book ratios show Japan is more in line with historical averages, albeit at a discount to global equities, which appear expensive at the moment.
The case for continued Japanese equity outperformance then rests on a view that the JPY will remain at low levels, inflation will stabilize without much monetary tightening, the global manufacturing/capex cycle (to which Japanese exports and large-cap equities are geared toward) will remain robust, and foreign inflows will push the market higher and narrow the valuation gap. While possible, it is hard to have conviction on this outcome, given the uncertainty facing the global economy at the moment.
Instead, we think investors are better served looking at other segments of the Japanese market. There is a long tail of smaller and somewhat illiquid companies in Japan that still trade at below-book value valuations and some with cash balances larger than their debt or even market cap that are often cited as evidence of Japanese equities being “cheap.” New rules by the Tokyo Stock Exchange released in 2022 and 2023 are putting renewed pressure on companies to improve their governance, efficiency, and discounts to book value by boosting shareholder returns via buybacks and dividends. This should benefit activist strategies in Japan, which target such companies, as well as buyout funds that are also riding a wave of corporate succession deals, given Japan’s aging demographics and other corporate actions (take-privates, conglomerate divestments/spinouts). While we are concerned about a reversal in the JPY weighing on the overall market in the near term, fundamentally the JPY is very cheap and likely to appreciate over the coming years. This should benefit long-term investors in such strategies, especially as Japan benefits from the restructuring of global supply chains away from China.
Aaron Costello, Regional Head for Asia
Vivian Gan, Associate Investment Director, Capital Markets Research