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In late February, Nomura Securities, Japan’s biggest brokerage house, took the highly unusual step of inviting journalists into its headquarters in the heart of Tokyo’s financial district. Employees ushered them to the inner sanctum of its equities trading floor — a quietly frenetic, L-shaped chamber, usually strictly off limits to outside eyes.
But this day was different. The Nikkei 225 Average of major Japanese stocks had been on a powerful rally since January and, closely followed by Japanese media and the general public, was about to smash through its all-time high — a level set in 1989, at the peak of the biggest stock bubble in human history.
But history, Nomura sensed, was finally about to be overtaken by momentum.
When the record was broken, the traders burst into applause. The big number — the Nikkei at 40,000 points — certainly told a neat story: after years of promised reform and resurgence, Japan was back. The country of Toyota, Sony, Tokyo Electron, SoftBank and Uniqlo was emergent, at last, from its “lost decades” of economic stagnation, falling prices and zero wage growth.
By the end of March, and with foreign investors tentatively buying into the euphoria, the combined market capitalisation of Tokyo-listed stocks hit quadrillion territory — ¥1,000tn — for the first time. And all of this happening while China, for geopolitical reasons, was becoming less of a destination for western capital.
As one fund manager put it to me: “For 30 years, the investment has been all about Asia ex-Japan. Now the biggest game in town is Japan ex-Asia.”
It has been a time for UK investors, among others, to look afresh at Japan, a country that, 35 years ago, presented a story of astounding expansion and acquisition and seemed poised to overtake the US as the world’s biggest economy. But is now the time to buy — or are investors simply getting caught up in a great story?
The resurgence of the Japanese stock market certainly makes for a compelling narrative, but it’s one that is yet to convince completely, particularly as the sharp decline in the yen has wiped out much of the dollar- or euro-denominated gains made by foreign equity investors this year.
For some, the Japanese story is one of unlocking trapped value. For others, it is about re-rating the country as a pivotal tech player.
“Japan is the perfect market to invest in for anyone who thinks that they’ve missed the boat on US tech stocks,” says Pelham Smithers, a longtime Japan analyst. For investors who wished they’d got into Nvidia, he counts more than 50 Japanese stocks related to AI, from SoftBank Group, owner of chip designer Arm, to Hitachi, provider of arguably the largest industrial AI platform in the world. “You get all this for about half the valuations you pay for the Nasdaq Composite,” he says.
Scott MacLennan is less enthusiastic. The global equity portfolio manager at Schroders in London has spent a week in Tokyo visiting companies and attending presentations aimed at foreign investors. “My overriding sense is that, while the Japanese market is still at a very exciting juncture . . . it is important to be mindful that after a period of sustained strength we may now be moving into a period of digestion,” he says. “I would be cautious about getting too bullish, even if it is very attractive on a multiyear basis.”
It is a caution that, for now, seems widely shared. Since its epic breakthrough three months ago, the Nikkei 225 has traded sideways. The much broader Topix index, though up a respectable 15 per cent year to date (in local currency terms), has also lost much of the energy with which it began the year.
Japanese companies have certainly been working to meet investor expectations for greater returns on equity and a greater focus on the cost of capital. Share buyback announcements by Japanese companies in the last financial year exceeded ¥10tn for the first time ever, according to Goldman Sachs strategist Bruce Kirk, and he estimates that a record ¥1.2tn of buybacks were then announced in April. Still, net buying of Japanese stocks by foreign investors — including individual investors in the UK — has been relatively anaemic.
There is background excitement around the introduction, in January, of an expanded tax-protected investment scheme (structured much like a UK Isa and known as Nisa) and its capacity to draw into the Tokyo stock market some of the $7tn that Japanese households currently hold in cash.
The so-called “Mrs Watanabes” — a moniker given to stereotypical keepers of the family purse strings — are generally conservative, but deflation has made them more so. When prices were stagnant or falling, there was no pressing need to take risks seeking higher returns on savings. That hoard of cash and deposits represents more than half of the households’ total financial assets, and is a far higher ratio than their peers in the US, UK and Europe, and than the worldwide average of 28.6 per cent.
For a country that has accumulated such vast household financial assets — ¥2.1 quadrillion at the end of June 2023 — it is remarkable how little has flowed into the stock market.
Now, the Japanese government and Tokyo Stock Exchange are aligned in a quest to change that.
Brokerage firms are desperate to loosen investor caution, both domestically and globally. At the end of May, two conferences held in Tokyo by Morgan Stanley MUFG and CLSA, drew an estimated 1,500 fund managers from around the world. Among them were sovereign wealth funds from the Middle East, pension funds from Canada and Latin America, and family offices representing significant pools of Chinese, Indian and South East Asian wealth.
They had arrived at the right time, one delegate told me, the manager of a large global fund that does not comment officially to the media. “A lot of investors and analysts are focused on the many changes that are going on at Japanese companies.”
Whether that change is coming from the Tokyo Stock Exchange cajoling companies into being better stewards of shareholder equity, or the government making it easier for companies to consolidate, or whether it is big activists like Elliott and ValueAct coming to shake things up, there is clearly change happening, he adds.
“But from my point of view, the really important factors at work here are macro ones, and the background has never been so bullish,” he says. “We are moving from the world of zero — where inflation, wage growth and interest rates were all negligible — to the world of two, where inflation, interest rates and wage growth are all rising. That’s a big, investable change.”
Morgan Stanley’s conference began with an appearance by the prime minister, Fumio Kishida — a leader whose approval ratings are extremely low, but who has been at the helm just as many of the biggest economic policy initiatives of the “Abenomics” programme of the late Shinzo Abe have borne fruit.
Kishida’s message was straightforward — and, according to at least one delegate, calculated to address the sort of criticism that has held many global investors back from taking the plunge.
Japan has broken free of the deflation that held it down for a quarter of a century, the PM said, and, as prices begin to rise, so household and institutional investors will feel pressure to build themselves a hedge against inflation. Japan will transition to a new growth-oriented economy.
“In order to financially support this virtuous economic cycle, we are strongly promoting the establishment of an asset management nation,” said Kishida.
As that process works itself through, and the “Mrs Watanabe” Japanese households become more actively invested in Tokyo stocks, valuations across the entire market would increase. The current price-to-earnings ratio of the Topix index of 17x, estimates Morgan Stanley, could rise to 20x by the end of 2030 in a base case, and 22x in a bull case.
“Why is this time different?” was the question posed by CSLA’s Japan strategist Nicholas Smith, at the investment group’s conference several days later. The market has had rallies at various points over the past three decades, often driven by narratives of market reform or some fundamental change in the activities of households, companies and the economy as a whole. Those rallies consistently proved shortlived and left many investors badly singed.
Smith’s line, which investors at the conference generally agreed was persuasive, was that, this time, they were watching something extraordinary. Inflation is back; the odds of the Bank of Japan raising interest rates before October are rising; wage increases in 2024 have been the largest in 33 years and the prospect of them rising even higher are guaranteed by the fact that every single industrial sector in Japan is now short of labour.
A deck of more than 60 slides further pointed to a market in rude health — the potential of which Japanese institutional and individual investors have still not recognised. Japanese investment trusts, pension funds and insurance companies, said Smith, hold respectively 26.9 per cent, 9.1 per cent and 6.1 per cent of their portfolios in equity. That compares with 61 per cent, 28.1 per cent and 11.1 per cent by their US equivalents.
Over the past decades, the 12-month forward earnings per share of Topix stocks have (in local currency) outperformed peers in the US, Germany, China and the MSCI Emerging Market index. The profits of corporate Japan, Smith showed, are overwhelmingly correlated with global industrial production and world trade, rather than with US 10-year Treasury yields, the dollar-yen exchange rate or Japanese industrial production, as many imagine.
“Every investor left the CLSA conference abundantly aware that corporate Japan sits, like the dragon Smaug, on a deep bed of unproductive gold,” said Smith. “As problems go, it’s a great problem to have.”
Even those who agree with that argument, however, see across-the-board gains as unlikely given the wide variations of quality among Japanese companies and the difficulty playing the Japanese market as stock selection becomes more critical to success.
“The companies that have a more international mindset and understand how inflation works elsewhere will be the ones that are more able to adapt in contrast to those which are more reticent about raising pricing and cutting costs,” says Schroders’ MacLennan. “The risk is that, for those companies which are more slow to act, inflationary forces will be stronger than they will have prepared for,” he adds.
James Salter, founder of UK-based Zennor Asset Management and a veteran of Japanese markets, says the easy money has, at this point, already been made.
The problem is that the market is bifurcated, he adds. There is a very sharp difference between large-cap companies, such as Toyota, doing a lot for shareholders, and then lots of companies in the sub-$2bn market cap category that are not doing quite enough. Some of the strongest- performing Japanese stocks in the past year have been the five major Japanese trading houses, Mitsubishi, Mitsui, Itochu, Marubeni and Sumitomo. Warren Buffett’s Berkshire Hathaway has become the largest shareholder of each. Although limited to just five stocks, the investment, Berkshire’s first in Japan, was widely seen as a huge endorsement of the Japanese market story, and continues to reverberate.
“If you look back over a year and a half, and you bought the trading houses post Buffett, the automakers and the tech stocks related to AI like Tokyo Electron, you were where you wanted to be,” says Salter. “But if you go down the spectrum it’s more complicated and while delivery of shareholder returns has often been good, everything is still conservative on growth prospects.”
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