Japan: Reclaiming Lost Decades

• Pro-market reforms are pushing companies to improve shareholder returns. Japanese companies have long hoarded cash, reaching $2.5 trillion, bloating book values but offering little return in a country where interest rates on cash remain below zero. Currently, about half of the 1835 listed firms on the Tokyo Stock Exchange have Price to Book (P/B) ratios below 1.0, including some very large, well-known companies. Earlier this year, the Tokyo Stock Exchange had made changes requiring these companies wishing to list on the Prime and Standard sections to provide plans to boost their P/B ratios above 1.0 as soon as possible. This regulatory push is meant to encourage putting idle cash to use in the form of stock buybacks and other measures to help improve shareholder returns.
• Japan's GDP growth is exceeding the U.S. and other Group of Seven nations this year. Japan's GDP expanded an annualized 2.7% in the first quarter, much higher than economists' forecast of 1.9%. Several factors are helping drive growth, the most substantial of which may be something the Japanese economy hasn't consistently experienced since the 1980s: inflation. After decades of flat to falling prices, the year-over-year pace of inflation in April was 3.5% and has now been running above the Bank of Japan's targeted 2% for 13 straight months. This is the first time an entire generation of consumers and businesses have experienced sustained inflation. Previously, falling prices provided an incentive to delay consumption, which handicapped economic growth. But now, rising inflationary expectations could lead to positive changes in consumption and investment by Japanese individuals and corporations helping drive stronger growth.

• Japan may benefit from the "de-risking" of supply chains in Asia. Japan welcomed leaders of the Group of Seven (G7) nations for a summit in May. As leaders seek to mitigate economic security concerns by "de-risking" critical supply chains amidst anti-China consensus buildup in Washington and Brussels, Japan represented Asia as a low-risk investment destination. The event was accompanied by meetings between Japan's Prime Minister Kishida and executives from many of the world's biggest semiconductor businesses (TSMC, Samsung, Micron, Intel, IBM, and Applied Materials) that have the potential to result in significant manufacturing coming back to Japan. Japan, through the efforts of the Ministry of Economy, Trade, and Industry (METI), has already unveiled 1.3 trillion yen in subsidies to attract semiconductor companies, with seven manufacturers recently announcing investments. At the same time, Asian emerging and frontier markets are seeing gains in low-cost export businesses being moved from China. As these economies invest in capital and infrastructure to facilitate this transition, Japanese industry has a leading position to supply them with construction equipment, trucks, robots, and machine tools.
• Monetary and fiscal policy support. The Bank of Japan (BOJ) remains a global outlier, having not yet raised rates this cycle, despite inflation surpassing their 2% target. The slow approach to rate hikes is likely helping the performance of Japanese stocks, even if it has weighed on the yen. This slow approach also has meant that, Japanese banks have not suffered the rising interest rate issues that plagued U.S. banks. The BOJ could change course and raise rates or alter its yield curve control policy that keeps interest rates in a tight range around zero. The BOJ's zero-interest-rate policy since 1999 makes it is hard to foresee all the consequences of abandoning their current policy—even if done slowly and marginally. Yet, a likely result of moving toward tightening monetary policy is support for the yen. Higher yields and a stronger currency may prompt Japanese investors to move their substantial savings out of foreign investments back home into Japanese stocks and bonds.

• Money flows are favoring Japanese stocks. Foreign investors were net sellers of 27 trillion yen of Japanese stocks between 2015 and the end of 2022. But this year, Japan's Ministry of Finance reports that Japanese stocks have seen rising net foreign inflows this year; foreign investors are increasingly seeking exposure to Japan, with Warren Buffett among them (Berkshire Hathaway said on Monday that its wholly owned subsidiary National Indemnity Company increased its stake in five Japanese trading firms to average more than 8.5% after a prior increase to 7.4% was announced in April). The 12-week moving average of net inflows by foreigners into Japanese stocks is the highest in the more than 20 years. Japan's domestic demand for stocks may also be on the rise, supported by fiscal policy. Starting next year, the tax-free amount Japanese households can invest in equities as part of the Nippon individual savings accounts will double in size, and investors will no longer have a 20-year cap on the tax-exempt period. A shift to an inflationary mindset may also encourage investors to move away from holding cash into investments with the potential for higher returns.

• Japanese stocks remain inexpensive. Japanese stocks currently trade at a price-to-earnings ratio of 14 on 12-month forward earnings estimates, which is below the 20-year average for the MSCI Japan Index. That compares to an above-average 19 for the U.S. S&P 500 Index. Japanese stocks are inexpensive relative to U.S. stocks today.

• Pro-market reforms may fail. A push to improve corporate governance in 2014-2015 under former Prime Minister Abe did not significantly alter the valuation of Japanese stocks, which have long been viewed as inexpensive and a "value trap." Monitoring cash levels may be an important indicator.
• Slower global growth may weigh on exports. Slowing economic momentum in China, Japan's largest trading partner, could weigh on growth. Japan is also an export-dependent economy and could be adversely affected if global growth is weak. An upcoming signal of momentum is the widely watched Tankan quarterly assessment of business conditions in Japan issued by the Bank of Japan is due on July 1.
• Japan's aging population. Japan's aging population had tended to restrain growth and inflation, although Japan has some unique advantages in combating this drag relative to other countries. First, unlike many developed economies where the domestic population is the largest customer base, more than half of the sales of Japanese companies are outside of Japan (e.g. big Japanese companies like Sony and Toyota get 70-80% of sales outside of Japan) mitigating this risk. Second, the potential wave of capital spending could boost output per worker in Japan, whose productivity is among the lowest of the G7. Third, the costs of an aging population are much less of a drag for Japan than the United States. Japan is aging more quickly than the U.S., but health care costs per capita for Japan ($4,378 during pre-pandemic 2019 according to the World Bank) are a fraction of those in the U.S. ($12,914 during pre-pandemic 2019), per the U.S. Centers for Medicare & Medicaid Services.
• Japanese stocks have seen a powerful rally already. Strong net money inflows and 10-week winning streak have pushed Japan's stocks to a 33-year high. Japanese stocks might consolidate recent gains.
• Ultimately, Japan's debt growth may be unsustainable. As of December 2022, Japan's government debt is 263% of GDP, double that of the U.S. (123%), and the highest of any developed nation according to the International Monetary Fund (IMF). To help finance this debt, the Bank of Japan has bought half (52%) of all Japanese government bonds, known as JGBs. This is more than double the share of U.S. government debt owned by the U.S. Federal Reserve (20%). This large growth in debt financed with low interest rates has weighed on the value of Japan's currency. The yen has fallen nearly 25% against the dollar since the end of 2020, when the bank's self-imposed ceiling on purchasing JGBs was lifted in response to the pandemic. This effect on its currency may eventually act as a market-imposed debt limit on Japan, but since Japan has a high savings rate and can finance its debt without relying on foreign investment, it is not clear how high the domestically financed government debt can grow without adverse effect.

Japan's stock market may continue to surprise investors as it nears an all-time high, reclaiming its lost decades of performance. However, the uniqueness of Japan's economy and businesses also pose risks. Further gains by the second largest stock market in the world can help boost the performance of international stocks.

Michelle Gibley, CFA^®, Director of International Research, and Heather O'Leary, Senior Global Investment Research Analyst, contributed to this report.