Still springtime for Japanese equities

AS JAPAN welcomes the sakura season, Japanese workers are enjoying their second consecutive year of salary increases, after decades of wage stagnation.

Each year, the spring wage negotiations (or shunto) bring together unions and management to negotiate wages ahead of the start of Japan’s fiscal year in April. This year’s wage round has concluded, and Japan’s largest companies have agreed to raise wages by 5.28 per cent, higher than the 3.58 per cent seen last year.

Wage hikes need to be set against Japan’s inflationary backdrop, with core inflation at a four-decade high of 3.5 per cent. With the 2 per cent inflation target and potential wage increases in sight, the Bank of Japan (BOJ) finally abandoned decade-long policies which were designed to fight deflation.

The BOJ made its historic decision on Mar 19, 2024, to lift its deposit rate from -0.10 per cent, set its new key interest rate at 0.00 to 0.10 per cent and remove its 10-year bond yield cap. Though this first rate hike since 2007 came earlier than our April forecast, Japan’s central bank kept a dovish outlook, maintaining that financial conditions would stay accommodative and gave no signal of imminent further rate hikes. Also, the BOJ said it is prepared to buy Japanese government bonds (JGB) if long-term interest rates rise rapidly.

Continuing the momentum from 2023’s 29 per cent gain (total returns based on the MSCI Japan Index), Japanese equities got off to a roaring start this year. The benchmark MSCI Japan Index is up 19 per cent in the first quarter, bringing its 12-month performance to an impressive 41 per cent.

From a valuation standpoint, the MSCI Japan Index is now trading at a 12-month forward price-to-earnings multiple of 16.6 times (as at Apr 1). Although this is 1.1 standard deviations above its 10-year average of 14.8 times, the market is still seeing positive upward revisions in corporate earnings.

At Bank of Singapore, we retain our year-long overweight position in Japanese equities in our tactical asset allocation strategy while urging investors to be positioned for the changing dynamics within the market.

Macro backdrop conducive despite currency volatility

Despite the BOJ’s recent rate hike, its monetary policy stance remains accommodative. As real interest rates in Japan remain negative in the near term, this remains a tailwind for the economy and asset values.

However, currency volatility may continue as the USD/JPY is largely driven by US-Japan interest rate differentials. Hence, the JPY can react to expected interest rate policies of both the US Federal Reserve (Fed) and the BOJ. Japan’s exit from a deflationary period may also allow the BOJ to respond to currency weakness with additional rate hikes or currency intervention.

Last month’s BOJ rate hike was followed by unexpected weakness in the JPY. However, the USD/JPY retreated from near the 152 level on news of a tri-party meeting with the BOJ, Ministry of Finance, and Financial Services Agency on speculation of imminent foreign exchange currency intervention.

How does the movement of the JPY affect Japan’s equity market? The correlation of Japanese equity market performance with the USD/JPY has been mixed in recent years given the diversified industry exposure of the overall Japanese market. Still, a sharp appreciation of the JPY could result in a short-term pullback in equity prices.

As we expect the JPY to strengthen over the next 12 months, this could be a drag for Japanese exporters, such as the automotive, electronic components, chemicals, biotechnology and pharmaceuticals sectors. Conversely, domestic-oriented companies with US dollar cost bases may benefit from stronger consumption and USD-priced raw material imports. Retail, food and beverage and real estate sectors are potential relative beneficiaries of JPY strength.

Yet, the effect of short-term JPY moves on Japanese stocks should not be overstated as companies may have already factored the impact of JPY shifts into earnings expectations for respective industries and sectors. Some companies also deploy currency hedging strategies to mitigate the impact of currency moves on their profitability.

Supportive picture: corporate and shareholder reform

With the Tokyo Stock Exchange’s ongoing push for Japanese-listed companies to carry out corporate reforms to enhance shareholder value, we see potential for increased dividends and share buybacks.

On the domestic front, Japanese equities are benefiting from higher retail participation in stock markets following improved tax incentives that came into effect on Jan 1, 2024, under the Nippon Individual Savings Account scheme. The rise in real wages and inflation expectations could prompt Japanese investors to increase their investments into capital markets for higher returns.

What this means for investors:

• Japan is a core developed market for global investors. In the context of a multipolar world, Japan offers diversification for businesses seeking supply-chain resilience and investors seeking diversified returns in highly liquid equities and fixed income markets. International fund flows into the market are set to rise as global investors re-evaluate Japan as an investment destination.
• Broader exposure in Japanese market. As the Japanese equity rally matures, we would broaden our focus beyond index investing to companies across the spectrum of attractively valued large, mid and small cap stocks with positive earnings and dividend growth momentum. We advocate a diversified approach across sectors such as financials, consumer staples, discretionary and information technology. Japanese banks and life insurance companies are also direct beneficiaries of BoJ’s monetary policy.
• Beneficiaries of long-term trends. Japan offers gems for investors seeking companies exposed to longer-term secular growth trends such as generative artificial intelligence, through its global leadership in semiconductor equipment, industrial automation and robotics. Cutting-edge technology innovation is also underway to alleviate the burden of the Japanese and Asian demographics – including an ageing population and shrinking labour force. 
• Focus on company fundamentals. Looking ahead, investors will focus on the upcoming earnings season, in anticipation of a broad-based earnings recovery, increased share buybacks and corporate restructuring (such as the divestment of cross-shareholdings). Real wage growth could drive a virtuous cycle of stronger domestic consumption, supporting price increases and margin expansion for Japanese companies. Rising productivity and improvements in return on equity for Japanese equities can also drive an expansion in price-to-book multiples.
• Risks of currency volatility to continue. We cannot rule out near-term currency volatility amid US inflation data, US Fed’s rate decision and potential rate hikes or currency intervention by the BOJ. Based on Bank of Singapore’s USD/JPY forecast over the next 12 months, an appreciation in the JPY could add on to total returns for investors in Japanese assets with unhedged forex positions. Investors unwilling to be exposed to currency volatility can hedge their exposure, but be prepared for the rising costs of doing so.

The writer is global chief investment officer, Bank of Singapore