Podcast: Is now the right time to go big in Japan?

The last time the Japanese stockmarket was at current levels the Berlin Wall was falling. Investment director Taku Arai discusses the renaissance in the land of rising stocks.

24/04/2024
Shibuya crossing in Tokyo, Japan

Authors

David Brett
Multi-media Editor
Taku Arai
Investment Director – Japanese Equities

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You can read a full transcription below:

Announcer (00:00)

Welcome to the Investor Download, the podcast about the themes driving markets and the economy now and in the future. I'm your host, David Brett.

David Brett (00:23)

The Japanese stock market, also known as the Nikkei 225, has been the somewhat forgotten equity market for the last three decades. The '80s were a boom time for Japan.

David Brett (00:39)

Just two decades ago, Japan was the second largest economy in the world.

News Clip (00:42)

And a decade before that, economists were busy making predictions about when it could even exceed the economic dominance of the USA.

David Brett (00:49)

But after the boom came a savage bust.

News Clip (00:53)

But by the 1990s, the country had entered a protracted recession. Stagnation took hold, and in 2010, China pushed Japan down to the world's third largest economy spot.

Taku Arai (01:06)

Because the bubble was really, really a bubble. And after that, Japan suffered a lot.

David Brett (01:13)

That's Taku Arai. Deputy Head of Japanese Equities at Schroders.

Taku Arai (01:18)

So there are a lot of the financial system crisis after 1980s, during 1990s. So after that period, the Japanese economy has been suffering all the financial system problem.

David Brett (01:33)

But now, Japanese stocks are back. December 1989 was the last time Japan stock market was at current levels. Back then, the dust was still settling from the fall of the Berlin Wall.

News Clip (01:45)

They've been pouring through the world nonstop, delirious with joy. The East German Trabant Sedans coughing and spluttering in the strangest traffic jams West Berlin has ever seen.

David Brett (01:56)

And Billy Joel was topping the US charts.

Taku Arai (01:58)

That Japanese stocks rebound really driven by the corporate fundamentals. So certainly that we're seeing very strong corporate earnings and a lot of changes going on during the corporate governance, corporate management. And on top of that was start to see the so-called return of inflation.

David Brett (02:19)

The revival began last year and has carried into 2024.

David Brett (02:26)

And with stocks back to where they were in the boom years over three decades ago, we'll look at what's happening and why and whether it can last. But in the first part of the show, we'll look back on an era where Japanese culture, its economy, and financial markets beguiled the world. We're heading back to the '80s.

Announcer (02:51)

On Apple Podcasts, Spotify, or wherever you get your podcasts, you're listening to the Investor Download.

David Brett (02:59)

For many the Nikkei's revival will bring back fond memories of Japan back in the 1980s.

Taku Arai (03:05)

It was really still my childhood, so I don't really remember much of that, but I remember the lot of anecdote that Japan was really strong, booming, economic animals, and Japanese companies, and very much doing quite well in the United States, for example.

David Brett (03:30)

It was a decade when Japanese culture and influence swept through the Western hemisphere, from its cuisines, such as sushi, and people learning the language, to growing references appearing in pop culture and arts, like the Nakatomi Plaza in the 1987 action blockbuster Die Hard.

Taku Arai (03:47)

8 Lincoln 30 to dispatch. 8l30, go ahead. Yeah, that's a wild goose chase over here at Nakatomi Plaza. Everything here is okay. Over.

David Brett (03:55)

The fascination was rooted in Japan's economic boom of the 1980s.

Taku Arai (04:01)

I think there's a lot of the story around that. But what I understand is that's really about the monetary policy or government policy that's really fuel the monetary base into the Japanese economy. And also, at the time, I remember that the Yen strength also or sudden Yen appreciation, also that lead to the more money into the Japanese asset price.

David Brett (04:38)

Tokyo real estate became phenomenally expensive. At the end of the decade, the Imperial Palace in Tokyo and its grounds were worth more than the whole state of California. The stock market was valued at a price to earnings ratio of 60. Compare that with the US S&P 500 now, which is just 24. For a brief time, the Japanese stock market made up 50% of the value of global shares, and then it all came crashing down.

Taku Arai (05:09)

Remember, that trigger was, I think, the Bank of Japan's policy. That was the... I don't exactly remember the timing, but that was the period that the Bank of Japan raised the interest rate, and that triggered the bubble buzz.

David Brett (05:26)

The tightening of monetary policy in 1989 seemed to affect stock prices. As lending costs increased drastically, coupled with a major slowdown in land prices in Tokyo, the stock market began to fall sharply. Years of sluggish economic growth followed. It saw the relative importance of Japanese markets dwindle. But now, the revival. What triggered it? That's coming up next.

Announcer (05:52)

Get in touch with us by email at schroderspodcasts@schroders.com or visit our website, schroders.com/theinvestordownload.

David Brett (06:03)

The Nikkei Index has risen by more than 40% over the past year, finally surpassing the 1989 peak, which symbolises the start of Japan's lost three decades and gives the new high more significance.

Taku Arai (06:17)

I think the Japanese company's effort to make their balance sheet healthy and they make themselves more profitable and more shareholder-friendly.

David Brett (06:32)

In the early 2010s, Japanese authorities recognised they had a corporate governance issue, so they took steps to introduce a stewardship code and clean up corporate Japan.

Taku Arai (06:43)

They're driving all the Japanese companies' governance structure, Japanese companies' mindset or attitude towards investors, and they're more thinking of the shareholder returns or thinking of the profitability. And we start to see real tangible outcome from the corporate earnings result over the last almost 10 years now. I think that's really drive all the background of the corporate fundamentals, and all the improvement of the corporate fundamentals. Of course, macroeconomic environment is very much supportive because the inflation is actually coming back.

David Brett (07:29)

For years, Japan was dogged by persistent deflation. Then, suddenly, along with the rest of the world, it was given an inflation boost, and Japanese companies had pricing power, the ability to raise their prices. That's because improving corporate governance and profitability also helped Japanese firms raise wages for workers. Last year, the so-called Shunto, a spring wage negotiation, saw wages grow by 3.7%, their highest in 33 years. All these improvements caught the eye of some very big global investors, including one in particular.

News Clip (08:04)

As you all know, Warren Buffett has been somebody who has always preferred Omaha over the financial centres of the world. It doesn't mean he's not interested in the financial centres, and he does visit from time to time. In fact, that's what he's doing this week. He is in Tokyo this week. It's the first time he's been here in 12 years, but he's come because he wanted to check in on the five trading houses that Berkshire bought a position in.

David Brett (08:29)

The billionaire investor revealed last May he'd raised his stakes in five Japanese trading firms after a visit to Japan and said he may consider further investments.

Taku Arai (08:40)

That was very much big news in the state or globally in the investment world.

David Brett (08:46)

I presume if Warren Buffet's interested, then the valuations of Japanese shares must have been quite attractive as well.

Taku Arai (08:52)

That's at the time, especially quite undervalued. The early 2023, that's the first quarter of 2023, the market was a bit subdued in during 2022 and early 2023, whereas actually earnings was quite strong, but the stock market was quite weak or tumbled, especially around the... You may remember the March 2023, there was some financial problem in the United States that also hit all the in the global financial market. And during that period, I think that the Japanese equity market is quite attractive in terms of valuation. So that's really the trigger of the Warren Buffet stuff, when the valuations are very much attractive among the global equity market. That's the first trigger for global investors looking into Japan.

David Brett (09:53)

Data from the Tokyo Stock Exchange showed foreigners invested more than 2 trillion ¥ in the exchange's prime offerings, its largest and most liquid stocks, in January. But with Japanese stocks already up 40% over the last year, the question on everyone's lips is, can the revival continue? That's coming up in the final part of the show.

David Brett (10:22)

We've had such a strong rally. Is this the time for investors to start taking profit or should they stick with Japanese shares?

Taku Arai (10:30)

I think that we certainly need to be careful of the some of the short-term setback or profit-taking activities because we think that a lot of the rally is very much driven by more short-term money, probably like the macro hedge fund, CTA type of more trend-following investors buying up a lot of Japanese equity. We can see that the index futures or passive investment is booming, that sounds more like a short term money. So we need to be careful on that the profit-taking activity. But from long term investor's perspective, we need to look at inside of the Japanese equity market. Yes, the rally is really driven by very limited part of the Japanese equity market, especially around the large cap, value stock or semiconductor stock. It's really the sweet spot is really limited or very much concentrated within the Japanese equity market. And we know there are a lot of Japanese company, Japanese industry has been the very good performer, very good earnings numbers, still very attractive variation.

David Brett (11:57)

Arai says stock prices for assets away from large caps and semiconductors haven't really responded to the rally so far.

Taku Arai (12:05)

There are still a lot of area in the Japanese equity market, namely more small cap space, more domestic-oriented company or domestic-oriented industry. They're left behind running this market rally since last year.

David Brett (12:20)

After decades of flirting with deflation, Japan is now experiencing more healthy level of inflation around the 2% level. And while most developed markets remain concerned about inflation, Japan has welcomed it.

David Brett (12:34)

We've mentioned the central bank in Japan a few times here. How much is the current market and the current economy relying on their monetary policy and the inflation outlook?

Taku Arai (12:44)

I think the Bank of Japan, they need to be, of course, very carefully managing their policy. I think the Bank of Japan is really mindful of their impact to especially not try to kill the inflation or economic growth in Japan by doing that rapid rate hike type of thing. So I don't think that really happened because I'm becoming more confident on the or a very reliable the Bank of Japan's policy action over the last one year or so since the appointment of the Mr. Ueda as a new governor. I think that the Bank of Japan will continue to be very supportive to the market or to the economy, and we're not really concerned about any significant move by that situation.

David Brett (13:50)

Stepping back to look at the big picture suggests that Japan could have more catching up to do. While the Nikki has set a new high, its gains pale in comparison in comparison to those of the US S&P 500 and even the Euro stocks 50, which have risen 14 and 50-fold, respectively, over the last 34 years. While the US accounts for around 17% of global GDP, its stock market represents just over 60% of global equity market value. Japan's economy was overtaken by China some years ago, but it's still the third largest in the world and accounts for some 4% of global output, yet only 6% weighting in global markets.

David Brett (14:32)

What's the reason for long-term positivity around Japan and stocks?

Taku Arai (14:37)

Because the fact that Japan market has been almost forgotten. The variation is very attractive compared to the strong growth potential, compared to the strong corporate fundamentals. So that's why we think we are very much still positive or constructive on the Japanese equity market based on that corporate fundamentals. Certainly, that's the biggest difference. And if we look back the 1980s or 1989, the bubble went the highest price. At that time, the price to earnings ratio was 60 times six, zero. Even after the was seen quite strong rally over the last one year, current valuation level is actually 16 times, one, six times. Meaning that it's not It's really stretched or not expensive from the valuation perspective. Yes, it went up to some extent, but it's yet quite reasonable range of the valuation. That means that that valuation or stock price was supported by the earnings from what we look at the price-to-earning ratio.

David Brett (15:57)

I'm glad. You're probably thinking that you're glad the rest of the world is now recognising Japanese stocks again.

Taku Arai (16:03)

Yeah, that's it. I'm quite confident that that come back long-term story, structure, shift, and long-term positivity around the Japanese equity market, and that will continue because this is very much structure shift of the Japanese equity market.

David Brett (16:25)

That was the show. We very much hope you enjoyed it. You can subscribe to the investor download wherever you get your podcast. And if you want to get in touch with us, it's schroderspodcasts@schroders.com, and you can find out much, much more at schroders.com/insights. New shows drop every other Thursday at 05:00 PM UK time. In the meantime, keep safe and go well.

Announcer (16:50)

The value of investments and the income from them may go down as well as up, and investors may not get back the amounts originally invested. Past performance is not a guide to future performance. The information is not an offer, solicitation, or recommendation of any funds, services, or products, or to adopt any investment strategy.

Authors

David Brett
Multi-media Editor
Taku Arai
Investment Director – Japanese Equities

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