In 23 years the Japanese market has never been more interesting

Source: Trustnet

I have been managing Japanese equity portfolios for 23 years. Out of all of those years I can honestly say that today is the most interesting time to be in the space.

Big changes we’ve been tracking for years are finally coming to fruition and Japan is at an inflection point. Investors and fund managers need to understand where we are and how we got here to make the most of the opportunities.

The really big developments are the long-awaited return of inflation and the Bank of Japan’s corresponding interest rate hiking. In addition, we’ve effectively done the easy ‘one-off’ phase of corporate governance reform, but there’s still more value to unlock.

To begin with let’s talk about inflation. Inflation is now back and it really looks like it is here to stay. The changes that have made this possible actually happened some time ago, but deflation is also a state of mind and Japan needed a catalyst to change people’s outlook. The aftermath of the pandemic finally allowed Japan to move past the deflationary mindset.

During the prolonged period of deflation, even providers of high-value-added products and services faced significant challenges in raising prices. The shift to an inflationary environment has changed this dynamic, enabling companies with compelling offerings to pass on higher costs and expand margins, thereby driving profit growth. The tight labour market is finally pushing up wages.

The return of inflation is going to prove to be an important factor in another major change: the narrowing of the interest rate differential between the US and Japan.

With the Bank of Japan now freer to raise interest rates given inflation has returned (if only gradually) the Federal Reserve’s probable cuts to interest rates will bring an end to the one-sided depreciation of the yen.

This should have a major impact on share prices. For foreign investors in Japanese equities, a weaker yen can erode returns. However, with concerns over further yen depreciation receding, investor appetite for Japanese stocks has strengthened and should continue to do so, providing support for the market.

The much-discussed Japanese corporate governance reforms are also entering a new phase. They have so far been responsible for some of the initial rally in the Japanese market, which began in 2022.

They’ve been successful in clearing out ‘zombie’ companies from the stock market and have dramatically improved shareholder returns. The changes have been quite transformative.

However, most companies have done the ‘one-off’ reforms, such as share buybacks, that lifted valuations. There aren’t as many easy wins anymore. This doesn’t mean the corporate governance push is over though.

Rather, the focus will shift to promoting efficient capital management. Companies will be encouraged to make investments to boost return on investment (ROI) and to avoid hoarding cash.

So what does all of this mean for the market?

Overall, it means we’ll see certain sectors oriented to the domestic economy perform well. In addition, we may well see a divergence in the performance of the best Japanese companies and the rest.

Inflation will really pay off for those companies with the most pricing power who can finally charge more for their product. Companies catering to the Japanese consumer will fall into this category. Supermarkets, hotels, construction and retail are set to benefit.

Rising interest rates will benefit Japanese financial institutions such as banks, who will now be able to charge more for loans. Bank profits have already risen significantly since the Bank of Japan started raising interest rates. There’s also been increasing demand for certain kinds of loans, especially for equipment to address labour shortages.

The end of the initial phase of the corporate governance reforms mean that many companies won’t be able to keep increasing their share price as they’ve bagged the easy wins.

We will instead see some of the best growth-minded companies that can make consistent, sensible investments to boost shareholder value pull ahead.

Amid these opportunities, it won’t pay to lose sight of certain long-term features of the Japanese market and economy. Like almost all developed countries Japan has an ageing population, but it is further along that curve than most.

At a time when deflation is over and it is possible to put up prices again you might consider the food industry as a sector where companies could start to charge more.

There have been prices rises in the space recently, with the price of rice going up. However, with a declining and ageing population, the food industry is still probably not a good bet for the long term given demand is liable to fall.

In short, Japan is waking up, and fast. Inflation is back, interest rates are rising, corporate governance is evolving and the yen is finding its footing.

For investors, this isn’t just a turning point – it’s a launchpad. After 23 years in the market, I’ve never seen a more compelling moment to lean in. The easy wins may be gone, but the real opportunities are just beginning.

Katsunori Ogawa, is the chief portfolio manager and founder of the SuMi TRUST Sakigake High Alpha strategy. The views expressed above should not be taken as investment advice.