The good times are almost over for Japan

japan nikkei
japan nikkei

The Japanese stock market is on a roll, hitting consecutive 34-year highs this week. The last time the Nikkei 225 index was at Wednesday’s closing level of 34,442 was in March 1990, a few weeks after the bursting of Japan’s property and stock market bubble on the final trading day of the 1980s.

Such was the scale of the spike at the end of 1989 that the market is still technically 13pc below its all-time high. But it was only above today’s level for a very short period. Essentially the Japanese stock market looks to have finally called time on three lost decades. It has been a long wait.

Human nature being what it is, investors are belatedly getting interested in the Tokyo market – far later than they ideally would have. The recent spate of “Japan is back” headlines may see this long-ignored market back on investors’ radars.

But after many years of banging the drum for the Nikkei, I am turning more cautious. Investors were wrong to dismiss the recovery in Japanese shares over the past 10 years or so, but they shouldn’t compound their error by jumping in feet first now.

2023 was a banner year for investors in Japan. Only the runaway Nasdaq did better than the Nikkei last year, at least in local currency terms. The weakness in the yen took the shine off performance for overseas investors but the 28pc return for the Nikkei and 25pc for its broader counterpart, the Topix index, were the best annual gains in a decade.

There are a number of reasons for last year’s rally. Japan was late to emerge from Covid, so it enjoyed many of the reopening benefits that we saw here in 2021, including a recovery of in-bound tourism and the release of pent-up demand from consumers freed from their long confinement.

warren buffet
Warren Buffett capitalised on currency movements that made the Japanese market look cheap to new foreign buyers - Paul Morigi/Getty Images

Their spending has helped Japan put an end to the energy-sapping deflation that has dogged the country for decades but it has done so without triggering the post-pandemic inflation that has been such a challenge in the rest of the developed world. Moderate inflation has settled in a 2-3pc sweet spot that has allowed the Bank of Japan to persist with the most supportive monetary policy of any developed economy in the world.

As a consequence, the yen is weaker today than at any point since the 1980s, a boost for a country that relies on exports and overseas earnings. While currency movements reduced returns for overseas investors, they also made the Japanese market look cheap to new foreign buyers. After years of neglect, there was no shortage of investors looking to remedy a significant underweight to Japan, most notably Warren Buffett.

One of the biggest drivers of investors’ renewed interest in Japan last year was a government-supported initiative to encourage companies to make themselves more attractive to investors both at home and abroad by prioritising the interests of shareholders.

Investors have tended to be something of an after-thought for Japanese companies. This is evidenced by the fact that around a third of companies listed on the Topix index have a market value that’s less than the book value of their assets. Just 7pc of comparable businesses in the US are this cheap.

There has long been a lack of urgency about working a company’s assets for the benefit of its owners. Half of Topix companies have spare cash on their balance sheets compared with less than a fifth in the US and Europe.

One of the ways in which companies can persuade shareholders that they are worth investing in is by increasing dividends and buying back shares. Both measures are running at historically high levels. But there is still a long way to go. The majority of shares listed on Topix are yet to disclose how they intend to boost shareholder value.

The trouble is that many of last year’s tailwinds look unlikely to persist very far into 2024. The Bank of Japan is showing a desire to normalise monetary policy now that inflation is becoming more entrenched. That should give the yen a lift, making Japanese exports less attractive even as demand slows on the back of rising interest rates in the rest of the world.

The growth advantage Japan enjoyed last year will also narrow as it gets back to a new post-Covid normality. And while the corporate governance reforms are welcome, the story is by now well understood. Japanese shares are no longer obviously cheap, on a higher multiple of earnings than their equivalents in Europe and the UK.

Longer term, there’s an even balance of pros and cons for investors in Japan. The biggest positives relate to a wall of money that could find its way into the market if encouraged to do so. Around half of the vast savings of Japanese households are held in cash with just 11pc in shares. That compares with the US, where 13pc of household wealth is in cash and nearly 40pc in shares.

One catalyst for changing that balance was implemented at the start of this month. Japan’s NISA (similar to our own ISA) saw its annual investment limit double while its previously time-limited tax-exempt period was made indefinite.

But for Japan’s stock market to make significant progress from here it must raise productivity fast to overcome the country’s deep-seated demographic deficit. Japan’s birth rate has been falling for years. At under 1.3 births per woman, it is well below the replacement rate. The population has been dropping for a decade and a half and is projected to be under 90 million by 2070, down from 125 million today.

The rise in Japanese shares over the past 10 years reflects concrete steps towards creating a more efficient and dynamic economy. Sometimes, though, it is better to travel than to arrive.

Tom Stevenson is an investment director at Fidelity International. The views are his own

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