After decades of economic and market stagnation, Japan may be on a path to sustainable recovery, reigniting investor interest in the opportunities Japanese equities offer in this new context. Experts from Vanguard believe that Japan’s paradigm is shifting, shaking off a previously resigned mindset. “The Bank of Japan may go further in its rate hike campaign, which began earlier this year, and the recent change in the country’s Prime Minister is unlikely to halt this momentum,” they note.
Shuntaro Takeuchi and Donghoon Han, managers at Matthews Asia, explain that many investors are understandably questioning the direction of Japan’s stock markets. It’s worth remembering that the market performed well until June but then shifted. The aggressive interest rate increase announced by the Bank of Japan on July 31 preceded weak economic data from the U.S. These factors combined to trigger an unexpected liquidation of yen carry trades, which wreaked havoc on global stock markets, especially in Japan. The Nikkei 225, or Nikkei Stock Average, dropped 12.4% on August 5, its largest decline since the day after the U.S. Black Monday crash in 1987.
“Japanese stocks recovered much of their losses in August, but volatility persists. Weak U.S. economic data and ongoing concerns about the sustainability of the artificial intelligence (AI) boom continue to cause sharp movements in stock prices, along with a strengthening yen. In our view, investors are likely to remain focused on macroeconomic issues. The Bank of Japan has indicated that more rate hikes can be expected, which could further strengthen the yen, while a U.S. rate cut cycle and a weakening dollar could negatively affect sentiment toward Japanese exporters. Moreover, if economic indicators start suggesting a further weakening of the U.S. economy, greater concerns about a slowdown in global trade—on which Japan heavily relies—could emerge,” they explain.
At Matthews Asia, the managers emphasize that recent exchange rate movements have not significantly impacted the profitability of high-quality Japanese companies. “In many areas, both for domestically oriented and international exporting companies, we continue to expect corporate earnings to grow at a mid- to high-single-digit percentage rate in yen terms, supplemented by healthy dividends and accelerated share buybacks, which could add another 2%-3% to total return potential. Japanese stock valuations are also attractive, trading at around 15 times earnings, roughly their average over the past 10 years,” state Takeuchi and Han.
Attractive Outlook
Beyond equities, experts at Vanguard believe that Japan’s structural changes extend beyond the impact on yield curves and currencies. The asset manager explains that in the past, surprise interest rate moves by the Bank of Japan (BOJ) made the Japanese fixed income market unattractive for foreign investors. Additionally, the BOJ holds the majority of Japanese government bonds (JGBs), creating an environment where prices and yields did not reflect true market forces.
However, they note that the BOJ has moved towards greater transparency, signaling its interest rate moves in advance. Although the BOJ still owns 55% of JGBs, it has reduced its holdings, increasing the likelihood that the yen will converge to its fair value.
For Vanguard, the conclusion for investors is that a market easily ignored in recent decades due to economic stagnation and BOJ dominance now appears to be a potential alpha source. “For better or worse, Japan has become much more interesting for investors, with market forces playing a more prominent role,” says Ian Kresnak, Investment Strategist at Vanguard.
According to Kresnak, in light of these changes, investors may consider their long-term asset allocation strategies. “A stronger yen would enhance the returns of Japanese stocks for a U.S. investor. Fixed income is a bit more complex. Higher interest rates would generate more short- to medium-term volatility, which a stronger yen could help offset. However, in the long run, higher yields indicate better future outcomes, reaffirming the role of Japanese bonds in globally diversified portfolios,” Kresnak concludes.
New Prime Minister
Investment firms agree that Japan’s new Prime Minister, Shigeru Ishiba, is a key factor in the country’s reactivation and the renewed attractiveness of its market. Mario Montagnani, Senior Investment Strategist at Vontobel, explains that Shigeru Ishiba’s unexpected victory in the race for the leadership of Japan’s Liberal Democratic Party signals a potential shift away from “Abenomics” policies.
The asset manager points out that Ishiba’s support for normalizing monetary policy and raising corporate taxes could significantly impact Japan’s financial landscape. Investors are reconsidering the prospects for Japanese equities and yen carry trades, examining how changes in interest rates, currency values, and fiscal policies could reshape investment strategies and market dynamics in the near future.
“We believe his emphasis on structural reforms, particularly the revitalization of rural areas, does not align with the growth-oriented approach of ‘Abenomics,’ which has supported Japanese stock prices in recent years. In fact, Ishiba previously criticized the BOJ’s aggressive monetary easing. Consequently, we believe investors may approach this shift in Japan’s political landscape more cautiously, potentially causing volatility or even a market correction in the short term, especially if expectations of aggressive monetary stimulus decrease. It’s worth noting that Ishiba himself recently downplayed speculation on this matter. Over the weekend, he emphasized that Japan’s monetary policy is expected to remain accommodative, implying a willingness to keep borrowing costs low to support still-fragile economic growth,” Montagnani explains.
Finally, Kelly Chia, an Asia Equity Analyst at Julius Baer, notes that Ishiba has reversed his stance on interest rates, fiscal stimulus, and tax increases, which has weakened the yen and helped to revalue stocks. She explains that after a period during which the stock market was affected by currency appreciation, recent developments under Japan’s new Prime Minister have changed market perspectives.
“Ishiba has reversed his stance in three key areas investors were focused on. He now supports keeping rates low (previously, he was in favor of raising them), has announced plans for a fiscal stimulus package (previously, he advocated for some austerity), and has backed off from tax increase plans. This was nearly the same approach the previous Prime Minister took upon taking office,” Chia explains.
The analyst’s main conclusion is that most investors already have a basic expectation that Japanese companies will improve profitability and increase shareholder returns, but she warns: “Failing to meet corporate reform expectations could lead to significant stock depreciation. Ishiba’s reversal from his previous stance has helped ease investor concerns.”
