investment insights
Weighing up Japan’s attractions for foreign investors
Key takeaways
- Japan’s economic fundamentals are solid with service sector and domestic capital expenditure offsetting other weaknesses. Inflation is set to overshoot the Bank of Japan’s 2% target for a consecutive year
- The BoJ may tweak or end yield curve control (YCC) policy this year, and markets may be dismissing this risk by ignoring nuances in the central bank’s official rhetoric
- The yen looks undervalued and we see it strengthening against the US dollar: our 12-month USDJPY target is 120
- We see little evidence that corporate reforms have significantly improved return on capital and valuations no longer look attractive versus long-term averages. We remain neutral on Japanese and global stocks, preferring high quality fixed income.
Japan may finally be seeing a lasting shift to positive inflation and long-term optimism. Japanese equities have already rallied thanks to markets’ recognising this fundamental, if still incomplete, economic progress. The attractions of Japan’s financial assets for foreign investors now depend largely on positive inflation and corporate governance reforms as the Bank of Japan considers how to end years of loose monetary policy, removing a key driver of the recent rally.
There are reasons to believe that inflation will prove more durable. Japan’s headline consumer price inflation (CPI) has moderated slightly from January due to government household energy subsidies. However, expectations for 2023’s average CPI inflation have risen from 1.8% at the start of the year to 2.8% in early July, reflecting the prospect of strong domestic demand and rising electricity tariffs (see chart 1). Japan’s core inflation, which excludes fresh food and energy, has long been close to 0% and is now at its highest level for more than four decades. At this point, Japan looks likely to register a second consecutive year of above-target inflation, in line with our earlier expectations.
Wage growth will strengthen the outlook further. After a brief decline in early 2023, wages are likely to accelerate again in the wake of one of the highest rounds of ‘shunto’ pay in recent decades; unionised salary negotiations delivered an aggregate rise of more than 3.6% according to trade unions. Japan’s services activity, boosted by booming tourism, is positive for wage growth since the sector employs around 70% of the national payroll. Still, investors should watch for unexpectedly strong wage growth data in the second half of 2023, as the economic environment may surprise, upsetting market pricing.
The country is set to post higher growth than comparable economies. Thriving services and resilient private sector investments took Japan’s gross domestic product (GDP) growth to 1.6% in 2023’s first quarter, despite falling real exports. We see enough momentum in domestic demand for a GDP increase of 1.2% for 2023, outperforming the US’s 0.9% and eurozone’s 0.7% this year. More importantly, investors’ long-term growth expectations have stopped deteriorating. Longer term, while poor demographics limit growth, the country’s importance in free trade deals, such as the Trans-Pacific Partnership, is positive in this ‘friend-shoring’ era.
Yield curve and yen
A brightening outlook increases pressure on the BoJ to tighten monetary policy. We expect the central bank to respond to strong inflation and renewed yen depreciation by adjusting its seven-year-old yield curve control (YCC) mechanism later in 2023. Since 2016, the policy has consisted of purchasing 10-year Japanese sovereign bonds to target a yield close to zero. Still, the BoJ has widened the band three times, in 2018, 2021 and 2022, from ±0.1% to ±0.5%, gradually reducing actual bond market interventions in defence of these yield targets.
The BoJ’s new Governor, Kazuo Ueda, who replaced Haruhiko Kuroda in April 2023, has not yet altered the central bank’s monetary policy, although he has begun a policy review expected to last between 12 and 18 months. We believe that market consensus relies on a literal reading of Mr Ueda’s review announcement. The BoJ cannot signal a YCC tweak without increasing pressure on itself to temporarily defend the target it wants to remove. Changing the YCC therefore must be a surprise. The vague ‘policy review’ definition may also make it more closely tied to short-term interest rates, not YCC.
Mr Ueda’s supposedly dovish language last week was cryptic at best. The BoJ may adjust policy once it is “reasonably sure” that inflation will keep rising into 2024, he said. Contrary to many interpretations, which see evidence for delaying a policy change until 2024, we see a risk that the BoJ is creating room to act before 2024 with change depending on revising forecasts.
Other factors thought to delay a YCC move are past, or not persuasive. The US debt ceiling crisis was averted and bank runs in the US and Europe are no longer key for monetary policy. A major monetary policy move in the midst of an election campaign in Japan would be awkward, but Prime Minister Fumio Kishida and his Party seem less certain about calling for a vote after a surge in popularity for their right-wing rival.
Furthermore, it is highly unlikely that a YCC tweak would lead to bank runs or the pension fund turmoil seen in the US and Europe. Japanese banks hold only a small share of their total assets in government securities, nor do Japan’s defined benefit pension funds usually engage in the liability driven investment (LDI) that troubled the UK: in Japan, actuarial liability matters and statutory rates move only gradually.
We expect the yen to strengthen against the US dollar, boosted by Japan’s improving growth and the prospect of an end to ultra-accommodative monetary policy. The currency looks extremely undervalued on several metrics, including relative to Japan’s improving trade balance. Our dollar-yen targets stand at 138 on a three-month basis and at 120 for a 12-month horizon. Likely currency market intervention by Japan’s Ministry of Finance and/or YCC adjustment may push the yen towards our short-term expectation. Forecasts for a stronger decline in the dollar depend on a slowing US economy and the risk of a recession there in late 2023 and early 2024. Any indication that the US labour market is loosening, as well as lower inflation in coming months, could strengthen the yen because it would allow the Federal Reserve to cut its benchmark interest rate in early 2024.
80s revival in equities?
Inflation is not the only thing breaking records in Japan. The Tokyo Stock Price index, or TOPIX, has gained more than 24% year to date in yen terms, taking the index back to levels not seen since the late 1980s. However, the attractions for foreign investors are more muted, given the yen’s sharp depreciation.
The TOPIX’s performance can be explained in part by a weaker yen and improving sentiment, thanks in part to expectations for improving corporate governance. Foreign investor interest has also intensified following the decision by Berkshire Hathaway to increase its portfolio exposures to Japan. Corporate buybacks in Japan are on track to be nearly as high in 2023 as 2022’s record JPY 9.2 trillion (USD 638 billion), according to SMBC Nikko Securities, a brokerage.
A positive view on Japanese stocks argues that rising dividend yields, share buybacks and better corporate governance are reasons to invest. Yet we see little evidence to date that reforms have translated into a significant improvement in companies’ capital allocations and return on capital. After the rally in Japanese stocks this year, valuations no longer look attractive versus their long-term averages, while the country’s exporters remain exposed to the global slowdown. On balance, we remain neutral on Japanese stocks, as we are on equities globally. We prefer high quality fixed income, including US Treasuries and investment grade credit.
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