Tokyo Trading Room
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The big story out of Japan this week is that the Nikkei 225 index hit a new record high as it finally surpassed the 1989 peak (see chart). It has now risen by more than 17% since the beginning of the year. The Topix index, a broader measure of the Japanese stock market, hit a 34-year high but is about 8% below its 1989 record high.
Japanese Nikkei 225 Index, 1980 to present:
1980-2024
FRED.StLouisFed.org
As the Wall Street Journal's James Macintosh points out, since the start of 2023, Japanese stock market indices have almost exactly matched the stellar performance of the S&P500 index in dollar terms. This is the case despite the Japanese stock market being relatively unaffected by artificial intelligence, which has been the main driver of the US stock market.
Markets' rise this year has been driven by strong domestic corporate earnings, a favorable outlook for exporters amid a weakening yen and the Bank of Japan's hesitation to end its negative interest rate policy despite higher inflation.
Nominal GDP has continued to grow due to price increases and is now about 6% above pre-pandemic levels. However, economic performance has not improved recently when adjusted for inflation: real GDP fell slightly in the fourth quarter, after an annual decline of 3.3% in the third quarter.
In a previous Forbes commentary, I pointed out that the revival of the Japanese stock market was largely influenced by renewed interest in foreign investors. Many had previously been underweight Japan relative to their benchmarks after the stock market bubble burst in the early 1990s and the stock market fell about 80% from its peak.
The appeal of Japanese stocks today is primarily that they offer good relative value relative to the US stock market. For example, based on Barclays' cyclically adjusted P/E ratios (CAPE), Japanese stocks compare favorably to U.S. stocks, even though the Japanese stock market has performed well recently. This was an important consideration in Warren Buffett's decision to increase his holdings in five major retail groups last year.
CAPE ratios: US vs. Japanese stock market (orange: Japan/blue: US)
CAPE ratio
Barclay
Another factor supporting the stock market is the depreciation of the Japanese yen against the dollar by about 35% over the past two years. This has boosted Japanese stocks for two reasons. First, it has improved the international competitiveness of Japanese companies, thereby helping Japan recover from the Covid-19 pandemic. Second, it has also increased domestic prices in Japan, raising hopes that the country's price deflation is finally over.
A third consideration is that Japan is seen by international investors as an alternative to China, where the stock market is suffering from capital flight due to concerns about its economic performance and increasing political tensions with the US. As a result, there are a growing number of international funds that exclude China or limit its weight in their indices. Japan and India were important beneficiaries.
Based on these considerations, I believe that international investors should consider Japan as a tactical asset, as many international investors are still underweight Japan and the country is benefiting from strong momentum. However, I'm not convinced it's a good game in the long run.
The main reason for my caution is that while the problem of deflation may have been overcome, the Japanese government is struggling to revive the country's dynamism in the 1970s and 1980s. Meanwhile, the economy's potential real GDP has fallen to 1 percent a year as the workforce has shrunk due to an aging population.
Against this backdrop, Prime Minister Kishida launched a “new capitalism” initiative in 2022 with the aim of boosting economic growth and reducing income inequality. However, the Financial Times notes that the word “reform” is missing from Kishida’s philosophy of corporate governance. Meanwhile, there is still strong resistance among Japanese companies to laying off workers when profits collapse. In this respect, Japan's “new capitalism” is still far from its US counterpart.
What should international investors do in these circumstances?
The successful strategy over the past two years has been to overweight Japanese stocks relative to international benchmarks while hedging yen exposure back into dollars. Since the stock market is off to a strong start this year, I'm inclined to maintain current positions. However, I would wait to increase equity exposure until there are clearer signs of when the Bank of Japan (BOJ) will end its negative interest rate policy and when the Federal Reserve will ease monetary policy.
Most BOJ watchers expect the central bank to gradually raise its key interest rate starting in April, given that headline CPI inflation is above its 2% target. But with the economy weaker than expected and the yen having recently depreciated above 150 against the dollar, the central bank must weigh the trade-offs of fighting inflation when the economy is weak.
In this regard, BOJ Deputy Governor Shinichi Uchida recently stated: “Even if the bank were to end the negative interest rate policy, it is difficult to imagine a path in which it would then continue to raise the interest rate quickly.” If so, go I expect the yen to likely strengthen once the Federal Reserve eases monetary policy, possibly in May. This would allow the Bank of Japan to raise interest rates without hurting the economy and the stock market, and international investors could then unwind their currency hedges.
I am a Ph.D. Economist (Stanford University) turned global money manager. My career began in the 1970s with stints at the U.S. Treasury Department and the Federal Reserve. I then worked on Wall Street for 25 years and held senior positions at Morgan Guaranty, Salomon Brothers, Prudential Insurance and JPMorgan Private Bank. I concluded my career as Chief Investment Officer at Fort Washington Investment Advisors, where I now work as an economic advisor.
Throughout my career I have written extensively about economics, financial markets and global investing and have authored three books on these topics in the last five years. I also appeared frequently on business television shows and in business publications. My goal is to help people understand what is happening in the global economy and financial markets so they can make informed investment decisions.
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