The Japan rally

Good morning. Ethan here; Rob is away this week. Fresh off their Unhedged debuts in April, the FT’s Jennifer Hughes and Kate Duguid will return in the coming days. Today, I discuss Japan, a personal fascination that has become headline-spanning market news. Email me: ethan.wu@ft.com.

Boom times in Japan

In March, when the Topix looked unremarkable against other stock indices, I wrote about the early signs of a transformation in Japanese markets. Less than two months hence, the Japan rally is in full swing. After Warren Buffett paid Tokyo a visit in April, global investors are rushing in, the Topix is at a three-decade high and Japan is lapping everyone else:

The rally rests on three pillars:

1. A shift in corporate attitudes towards shareholders, including activists. Any change this sweeping has many fathers. Some foreign activist investors have mounted successful campaigns to raise return on equity, which has long been paltry in Japan. The splashiest example is Elliott Management, which pushed printing conglomerate Dai Nippon to issue ¥300bn (then $2.2bn) in share buybacks, worth nearly a quarter of its market cap.

   Add to that pressure from authorities. The government’s plan to double asset income, to achieve a “new form of capitalism”, sets the tone. The Tokyo Stock Exchange has also been needling Japan’s many capital-inefficient companies, those with price to book ratio below 1, to shape up or face penalties. Though the penalties are years away, companies are starting to follow the new script. Buyback announcements in the 2022 fiscal year hit a record. Rie Nishihara, JPMorgan’s Japan equity strategist, told me that the TSE reforms are having perhaps their biggest impact through changing cultural expectations of management: “Japan is a culture where, even without regulations, it’s important to be a role model among your peers.” She notes that despite many companies pulling back in fear of a US recession, buyback announcements look resilient:

   

   And because only 20 per cent of first-quarter buyback announcements have come from companies with a P/B ratio below 1, Nishihara expects more to come.

2. Inflation is back. The pandemic and Ukraine war cost shocks forced companies to raise prices, something normally frowned upon. Might Japan finally slay its deflation monster? Inflation excluding fresh food and energy sat at 3.8 per cent in April, a four-decade high. Perhaps more importantly, there are some signs of wage growth rising, as workers reclaim lost purchasing power. Though real wage growth remains deeply negative, companies involved in Japan’s annual shunto wage talks have agreed to a 3.7 per cent pay increase, the biggest since Japan’s asset bubble burst in the early 1990s. Nishihara calls it “a transitionary period towards a new inflationary era”.

3. A sense that Japan is a haven market in a risky world, especially for China-shy investors seeking Asia exposure. Uncomfortably high recession risk in the US and Europe, plus China’s stock rally fizzling out, makes Japan look relatively inviting. The country could gain from friendshoring, too. Chip companies have announced ¥2tn ($14bn) in planned investment in Japan since 2021, reports Nikkei Asia, including names like Micron and Samsung. Lastly, investors wary of China, but who want proxy exposure to its growth story, see yet another reason to buy.

Put together, the Japan rally comes down to enormous changes at the right time. It is an alluring investment story. But it has its doubters.

1. There are signs inflation is failing to take root. Japanese inflation now has much to do with rising prices in one category, food, rather than a broader revitalisation of demand. Food inflation is a global problem, driven by the Ukraine war’s ripple effects in commodities, as well as one-offs like bird flu. Outside of tourism, services inflation is muted. Producer prices are falling. The problem is still about wages: without stronger, sustained increases, inflation will fall. The much-hyped shunto pay hikes are concentrated in a few industries like manufacturing, representing only 5 per cent of employees, Marcel Thieliant of Capital Economics told me. We’re at the “tail-end of the inflation cycle,” he thinks.

2. Corporate reform could disappoint. Measuring an attitude change is very hard, and Japan veterans note that management scepticism of investor short-termism runs deep. Take the recent stand-off between activist Yoshiaki Murakami and Cosmo Energy, the smallest of Japan’s three big energy firms (with a P/B of 0.7). Murakami wants Cosmo to raise ROE and spin off its renewable energy unit, while Cosmo’s president has resisted, suggesting Murakami is only looking to make a quick buck.

   Hani Redha, a portfolio manager at PineBridge Investments who made money in Japanese markets in the 2010s, adds that even if there are a growing number of companies trying to raise ROE, that may only be enough to draw in stockpickers. The bar for asset allocations to rethink Japan is high: “Culturally, getting enough [corporate reform] to happen that it moves the needle at the overall portfolio level, at an allocation level, it’s more difficult to see . . . You have an index with a lot of exposure to the auto sector, and that looks outright ugly to us. Japan is at the caboose when it comes to the [electric vehicle] transition.”

3. Japan is vulnerable to cyclical weakness elsewhere. Its stock market is full of exporters, meaning faltering global growth can fast become earnings weakness for Japan Inc. A US recession could be especially vicious. As the Fed cuts rates to help the economy, the tighter rate differential would lure capital to Japan, strengthening the yen. That, in turn, would make Japanese exporters’ goods more expensive in US markets, just as consumption is falling.

On balance, I’m still bullish on Japan in the longer term. The attitude change towards shareholders will take time, perhaps years, to play out, but it’s hard to deny that a structural change is happening. In the shorter term, though, I’m less optimistic. Given how high stocks have run, a reversal as global growth slows is probably coming in the second half of the year. That moment, when today’s optimism gives way to renewed Japan doom, could be just the right time to buy.

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