Japanese equities have fast become global investors’ most favoured developed market, with the Tokyo Stock Price Index (Topix) reaching a peak on May 17 not seen since August 1990, and the momentum is showing no signs of slowing down.

Despite being underweight compared to other developed markets, overseas investors have been net buyers of Japanese equities for six straight weeks, indicating growing confidence in the country’s economic prospects.

We believe the current market presents an exciting opportunity for investors to consider Japanese equities for several reasons. However, some challenges will need to be addressed for Japan to continue to shine in the long term.

Reasons to be optimistic

We believe several factors drive this newfound interest, pushing the stock index to its highest level in 33 years. Warren Buffett visiting, buying and eulogising the opportunities he sees in Japan has helped propel Japanese equities recently.

More specifically, the post-pandemic reopening of the domestic economy, the cheap currency, the economic growth fuelled by the re-opening of China, and the personal story of corporate governance reforms finally paying dividends are all piquing the interest of foreign investors towards Japan.

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From an absolute perspective, Japan’s Topix is up 14.1% year-to-date and trades on a 14.3 times P/E ratio based on the estimated earnings for the next fiscal year (FY1), while the S&P 500 is up 8.3% and 19 times.

Despite the strong start to the year, valuations remain very attractive, particularly when compared to the US, yet the real excitement and focus lie in Japan’s improvement in its historically weaker returns and governance.

In April, Japan completed earnings for the end of the fiscal year and guidance for the new year, and several trends are emerging. The domestic economy is recovering strongly post-pandemic, with domestic consumption rebounding and Tokyo and the bullet train packed with tourists.

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China’s economy is also re-opening and rebounding, and it remains Japan’s largest trading partner, boosting several Japanese exporters and industries. Therefore, investors are now considering Japan as an option to benefit from China’s re-opening without investing directly in China.

Moreover, the corporate governance reforms initiated by ‘Abenomics’ in 2015 have laid a solid foundation for higher shareholder returns, which are becoming increasingly evident. Activist hedge funds, domestic investors, and companies, followed by foreign investors, are all taking notice. Buybacks have been breaking records over the past four years, reaching an all-time high in the March 2023 financial year.

We believe that the market has yet to appreciate this trend fully, and as the discount to the US dollar continues to narrow and the market becomes more selective, overseas investors must identify companies with management teams willing to embrace the reforms and address existing issues.

The future is bright for Japanese equities

Given the current market conditions, we anticipate opportunities for investment in “quality growth” firms capable of consistently compounding earnings growth over time and “transformation” companies prioritising improvements in governance and shareholder returns.

We also see signs that the outperformance of value over growth in the last two and a half years is reversing, with growth looking oversold after a precipitous rotation. Japan’s favourable currency exchange rates could also create a supportive environment for growth stocks, and active stock selection and fundamental analysis are keys to identifying these companies.

While we are optimistic about the future of the Japanese equity market, several potential challenges must be navigated. These include the possibility of a global economic slowdown and the delicate task of normalising monetary policy without negatively impacting exporters.

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As such, it is essential to strike a balance, as tightening too much or too quickly could result in currency appreciation and harm the exporters that play a crucial role in Japan’s economy and the Topix. This could jeopardise the Bank of Japan’s efforts to generate inflation, an objective they have pursued for two decades.

Additionally, much work must be done to improve corporate governance reform. The Tokyo Stock Exchange has signalled dissatisfaction with the number of companies with a P/B ratio below one, and they are taking steps to address this issue. Companies with a low P/B ratio will face pressure not only from the Tokyo Stock Exchange and minority investors but also from their peers who are pushing for reforms and achieving better share price performance.

Despite the challenges the Japanese equity market may face, we remain optimistic and believe it presents a potentially promising opportunity for investors. The country is gradually recovering from the pandemic, and foreign investors are beginning to recognise the reforms implemented over the past seven years.

By prioritising bottom-up fundamentals, we are confident that opportunities and returns will arise for investors who can identify them. Furthermore, Japan’s historically undervalued market offers an attractive value proposition to overseas investors, making it even more appealing as an investment destination.

Daniel Hurley is a portfolio specialist for emerging markets and Japanese equities at T. Rowe Price

Sage shoots of recovery in Japanese equities

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