Where next for Japanese equities after record high?

The Japanese stock market has achieved a strong return so far in 2024, with the Nikkei 225 finally exceeding the bubble-era high seen in December 1989. Robust corporate fundamentals, improved governance standards and increasing demand from foreign investors have all contributed to the stock market’s robust performance. A key question for investors now must be whether the market can continue to advance.

What’s been driving Japanese stocks higher?

Many factors have contributed to the recent strength of the Japanese stock market, with growing earnings and improving corporate fundamentals among them. Profits from Japanese companies have been generally heading in the right direction, with the most recent quarterly earnings season seeing plenty of positive revisions to profit forecasts. In aggregate, this has meant earnings have also reached record highs and, as the chart below illustrates, this is forecast to continue in the years ahead.

The performance of domestically oriented companies has been particularly impressive, with many companies demonstrating strong demand and signs of regaining pricing power (the ability to raise prices in response to inflation) for the first time in decades. After years of entrenched deflation, the importance of this should not be underestimated.

When coupled with improved consumer purchasing power through wage increases, this should drive healthy levels of corporate earnings growth. Some of these higher profits can then be recycled back into the economy through further wage increases, driving a positive cycle of broader economic progress that has been largely absent from Japan for a generation.

Meanwhile, due to the ongoing efforts by the Tokyo Stock Exchange, corporate governance reforms have continued. These reforms are now resulting in growing interest from the global investment community, following a long period of overseas apathy towards Japanese equities. Share buybacks, in particular, have continued to increase as the market has risen and we would expect this to continue as more companies are compelled to improve their returns and address their persistent undervaluation.

Should investors be thinking about taking profits?

There is, perhaps, reason for caution in the near-term, given the speed and nature of the recent rally. Large cap stocks, which have ample liquidity, have continued to outperform. As a result, the valuations of many large companies, especially those in the Nikkei 225 index, have become somewhat stretched. We expect Japanese market leadership to migrate towards mid and small sized companies.

Other reasons for caution may include developments in currency markets and monetary policy. The Japanese yen has depreciated sharply.

Much may also depend on the outcome of this year’s ‘Shunto’, the big spring wage negotiations. Preliminary reports suggest that the average increase in wages in this year’s negotiations exceeded 5% for the first time in 30 years. Although this is further evidence of the return of sustained inflation in the Japanese economy, and therefore a positive for the long-term fundamental investment case for Japanese equities, it could weaken investor sentiment in the short term.

As has long been expected, the Bank of Japan has finally tightened monetary conditions by ending the negative interest rate policy.

Reasons for longer-term positivity

Despite these near-term vulnerabilities, there are many reasons to believe that we may have entered a period of sustained long-term outperformance from the Japanese stock market. Japan provides one of the most – if not the most – attractive opportunities to be found anywhere in the world. This is supported by solid corporate fundamentals, the presence of positive inflation and the return of pricing power for many Japanese companies.

Meanwhile, corporate governance reforms are likely to remain a structural driver, with investors, companies and regulators working together to raise governance standards, improve returns and bolster growth prospects. While the success of these initiatives is increasingly clear, there remains scope for considerable further positive progress in this area.

There has also been an influx of Japanese retail investors into the market under the renewed tax-exempt scheme known as NISA for individual investors. The upgrade to the NISA scheme allows individual investors to invest more assets with tax exemptions for an unlimited period. This change came at the right time, as the Japanese public has started to recognize the impact of persistent inflation on their financial assets.

During the last three decades of deflation, keeping money in bank deposits was the right decision, but that is no longer the case in an inflationary period. Thanks to strong returns from the Japanese equity market and ongoing inflation, new inflows into the market via the NISA scheme are expected to continue.

In combination, these factors have activated renewed appetite for Japanese shares from global investors. This demand should continue to grow as the positive domestic story becomes better understood. The overall valuation of the market looks reasonable, but this masks a considerable divergence between the larger companies that have become relatively fully priced, and smaller companies where valuations are, in general, much more appealing.