Japan stock market needs buy-in by domestic institutions, investors

THE Bank of Japan (BOJ) raised its interest rates for the first time in 17 years, ending its negative-interest-rate policy, about two weeks ago. It noted then that an upward cycle for wages and growth will likely be conducive to sustained inflation over the longer term.

Indeed, the latest Shunto wage negotiations yielded a pay increase of 5.28 per cent, a significant breakthrough in Japan, where real wages have stagnated for more than 30 years. This is a historic inflection point in Japan, with hopes that higher wages will lift consumer spending and prices in a sustainable manner.

More importantly, this symbolic acknowledgement by BOJ that deflation is finally defeated could persuade Japanese corporates to increase capital expenditure, driven by both higher consumer spending and an ultra-competitive Japanese yen.

The yen is trading near historical lows against the US dollar, potentially reversing the decades-long move by Japanese corporates to move production offshore.

Amid a deflationary environment, many Japanese corporates accumulated a significant amount of cash but with sustained inflation, becoming an unnecessary burden as real rates are deeply negative.

With an eye on cost of capital, there is a need to restructure balance sheets, either via increasing shareholder returns or through increasing investments in growth.

Although foreign institutional investors have piled into the Nikkei 225, propelling it to a new record high, there is still no compelling evidence that Japanese institutional and local investors are convinced by the above reasons. Most have yet to reallocate money out of Japanese Government Bonds (JGBs) into the Nikkei 225.

For instance, the restructuring of the Nippon Investment Savings Account (Nisa), which took effect on Jan 1 this year, led to an increase in flows into these accounts. But the bulk of these flows have overwhelmingly invested in foreign equities, especially US equities.

Under the new Nisa system, the annual investment limit for a regular Nisa account will be doubled from 1.2 million yen (S$10,702) to 2.4 million yen.

The limit for the so-called Tsumitate Nisa account, which has a longer tax exemption period of 20 years compared with five years for regular Nisa, will increase from 400,000 yen to 1.2 million yen.

Most importantly, the current limit on the tax exemption period will also be abolished, while the total lifetime investment limit will be raised from eight million yen to 18 million yen. The hope is that the expanded tax breaks will encourage greater retail investment in stocks. But thus far, success has been limited.

Playing catch-up

So why are Japanese institutional and local retail investors not participating in this equity rally? Do they know something foreign investors don’t?

The cynic in me would argue that one important driver for the strong performance of Japanese equities is the cheap yen and negative interest rates. In 2023, BOJ was the only major G10 central bank that had a real policy rate that was much lower at the end of the year than at the beginning of 2023.

In a year when almost all other G10 central banks were increasing interest rates and shrinking their balance sheets, BOJ kept its interest rates negative and not only maintained quantitative easing, but also controlled the yield curve of the JGBs via the Yield Curve Control strategy, keeping a lid on how high the 10-year JGB yields can rise to.

The end result was a near collapse of the US dollar/yen, which in turn propelled the Nikkei 225 to new heights, as export companies are a rather significant proportion of the index.

A weak yen would be positive for the margins of the exporters. Low commodity prices in 2023 meant a very weak yen would not lead to a significant jump in input costs for the companies.

But in 2024, we have an exact reverse of the above as most G10 central banks would be easing monetary policy, while BOJ should be very gradually tightening monetary policy. This would be sufficient for the bond yield gap to start narrowing, and hence lead to an appreciation of the yen.

It would also be naive to assume that just because Japanese workers get a sizeable 5.28 per cent jump in wages in 2024, they will likely increase their spending, which in turn will boost domestic consumption and the economy.

Although the wage growth this year surprised to the upside, it seemed more like Japanese employers are trying to play catch-up, as it came on the back of a measly 3.7 per cent growth in 2023. Japanese wages have been stagnant for several decades and in fact, that 3.7 per cent jump was the largest increase in three decades.

Furthermore, food prices jumped 8.2 per cent in 2023, the sharpest spike in 41 years, and core-core inflation – which excludes food and energy prices – rose by 3.7 per cent.

If Japanese investors were to rediscover their love for local equities, equities need to be seen as an attractive asset class. If the Japanese insurers and pension funds are convinced that the economy has finally climbed out of a three-decade long deflation, the logical asset allocation decision to make would be to rotate from JGBs into Japanese equities.

Call me a cynic but thus far, we have yet to see compelling evidence of this rotation.

The writer is chief investment officer for South Asia-Pacific, UBS Global Wealth Management