IN FOCUS6-8 min read

Has Japan’s stock market resurgence run out of steam?

Japanese shares had a stellar first half of 2023 but momentum has since halted. We look at the factors that might drive further gains from here.

23/10/2023
Japan autumn view

Authors

Masaki Taketsume
Fund Manager, Japanese Equities
Taku Arai
Investment Director – Japanese Equities

Japanese shares had a strong first half of this year, hitting 33-year highs. That upward momentum then stalled over the summer as investors debated the next moves for US interest rates and the chances of a global recession. But we think the resurgence of Japanese equities has a lot further to go.

Earlier this year, we discussed the multiple reasons behind the Japanese market’s strong performance in the first half of the year (see Japanese shares have hit 33-year highs – but why?). Some of these reasons were short-term ones, like Japan’s delayed re-opening after the pandemic. But others are set to develop over a much longer time frame.

Foremost among these is Tokyo Stock Exchange’s (TSE) call for companies to focus on enhancing their corporate value, as well as the return of inflation and wage growth. On both fronts, we see progress while recognising that these are trends likely to play out over years, not months.

Corporate governance

Investors in Japan have been waiting a long time for improvements in corporate governance. But change is coming, and was kick-started earlier this year by TSE’s call for listed companies to focus on achieving sustainable growth and enhancing corporate value.

This call was particularly directed at companies with a price-to-book (P/B) ratio of below one (meaning that the market is valuing the company at less than its assets are worth). The companies were asked to develop a plan for improvement, disclose that plan, and then implement it and track progress.

Chart showing difference in price to book ratios of  European, US and Japanese indices

We met recently with TSE and there are encouraging signs that their call is being heeded. As of mid-July, 31% of companies on the Prime Market had made a disclosure of initiatives they plan to take.

As we might expect, large companies with a P/B below one have so far been the most proactive. Smaller companies – who are perhaps less well-resourced – have made less progress with disclosure. And companies with a P/B above one have made less progress than those whose P/B is below one.

Chart showing % of Japanese firms making disclosure of plans to improve corporate value

Fast and slow measures to improve corporate value

We are encouraged by this progress so far but it is of course early days. We think there is more to come as TSE nudges Japanese companies’ management. We can call it peer pressure, but this is going to be highly effective.

TSE wants companies to achieve sustainable growth and enhancement of corporate value over the mid- to long-term. There are many ways to do this but they often take time. TSE itself gives the examples of “investment in R&D and human capital that leads to the creation of intellectual property and intangible assets that contribute to sustainable growth, investment in equipment and facilities, and business portfolio restructuring”.

While these longer-term initiatives are needed for sustainable growth, there are measures that can help boost corporate value in the near term. Unwinding some of the cross-shareholdings that many listed Japanese firms hold in each other is one such measure.

Cross-shareholdings can tend to enable management complacency, discourage risk-taking and make companies less responsive to the needs of smaller shareholders. But many Japanese banks have already sold their cross-shareholdings and other companies are following suit amid the pressures coming from the corporate governance code and investors themselves.

The unwinding of these cross-shareholdings could also enable companies to use the proceeds for shareholder-friendly measures such as increased dividends or share buybacks. That would be a quick way for companies to deliver a tangible benefit of the type being sought by TSE, while they also focus on actions with a longer time horizon.

Chart showing cross-shareholdings of Japanese companies

Promising signs on inflation

Next, let’s take a look at the macroeconomic backdrop. After a prolonged period of low or even negative inflation since the 1990s, the post-pandemic pick-up in inflation has been more welcome in Japan than elsewhere. The latest (August) inflation reading showed an annual rate of 3.2% - above the Bank of Japan’s 2% target but not dramatically higher as has been the case in other countries.

Inflation is important. If companies can put through price increases then they have confidence to increase wages. This translates into stronger purchasing power for households, leading to further increases in demand, which then leads to improving sales and profits for companies, etc. It’s a virtuous circle, but one that has been missing in Japan for many years, forcing companies to focus on cutting costs instead of raising wages or otherwise investing in their businesses.

Chart showing inflation expectations of Japanese companies

Japan is indeed cheap on various metrics including traditional “Big Mac index” or recent “Starbucks index”. If we look at the minimum wage level across the world, Japan also sits on the cheaper side among developed economies, meaning we have meaningful room for price and wage hikes.

Demographic challenges may help wage growth

As things stand, wages in Japan have been ticking higher, with positive wage growth for 19 consecutive months. Recent data showed a rise of 2.9% year-on-year in May but smaller increases of 2.3% y/y for June and 1.3% y/y for July. That still leaves wage growth lagging behind inflation.

We do see reasons for wages to keep growing though. Corporate profits reached a new peak in the April-June quarter because companies were able to pass cost increases through into selling prices. That bodes well for future wage growth.

Japan’s demographic challenges may also see employees gain more power in wage negotiations. Japan’s working age population is shrinking more rapidly than that of many other developed countries. The Bank of Japan has said that “it seems highly likely that, if the economy continues to improve, competition over human resources will become more intense and wage growth will rise”. 

Potential super cycle for Japan triggered by inflation

Inflation means there is a “cost” to holding cash, and we can foresee behavioural changes by households and corporations, both of which hold a lot of cash. In a deflationary environment, cash is king, so such behaviours were actually quite rational. Households retain substantial cash in bank deposits rather than investing.

This will change going forward and the Japanese government made an interesting and bold action to introduce a new scheme for individual savings account, so called “NISA”. Furthermore, we think corporations will also strive to use the idle cash on their balance sheets, mainly to improve productivity.  Capital expenditure remains strong and we expect this trend will continue in the inflationary environment.

All in all, we continue to see a positive outlook for Japanese shares and as active investors, we can find many opportunities in individual companies which benefit from such pivotal changes in Japan.

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Authors

Masaki Taketsume
Fund Manager, Japanese Equities
Taku Arai
Investment Director – Japanese Equities

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