The Trifecta Driving Japan’s Stock Market Rally

  • Inflation returns, the BOJ ended its negative interest rate policy
  • Corporate governance reforms drive valuation expansion and enhance shareholder returns
  • Favour domestically-oriented sectors, semi-conductor equipment industry, banking and financial sectors

The Japanese currency briefly dipped below HK$5 per 100 yen in late April -- a delight to Hong Kongers visiting Japan. Apart from being a popular travel destination, Japan has also become a hub for investors. Japanese shares have risen about 20% in the first quarter, but BEA Union Investment sees the rally has room to run further, for three reasons: monetary policy normalisation, reasonable valuations and corporate reform.

The Bank of Japan (BOJ) finally puts an end to negative rates, raising overnight lending rates to 0%-0.1%, marking its first rate hike in 17 years. The central bank also scraps its yield curve control policy. Let's set aside the deep-rooted perception that monetary tightening must be a bane to stocks, as the situation varies from country to country. Japan has since introduced negative interest rates starting 2016 in hopes of stimulating growth, but that fails to boost consumer spending and leaves the economy in doldrums. Unlike other developed countries where inflation brings headaches to the society and central banks, Japan has long been stuck in a deflationary spiral, stymieing consumption and investment. End-2023 data showed that about 52.6% of Japanese households had stashed their financial assets in cash. Why make big-ticket purchases today when the items can be bought at lower prices in the future? Dwindling consumer demand has taken a toll on corproate earnings and willingness to invest. This explains why Japan's economy and productivity stayed stagnant in the past.

Today, with Japan's inflation comeback appearing sustainable, coupled with a meaningful increase in wages and rising capex, this virtuous cycle serves as an ideal backdrop for the BOJ to step away from its era of negative rates. In addition, the authorities have recently relaxed the country's tax-free investment scheme - NISA, the acronym for Nippon Individual Savings Account. To encourage investment, the government expands the tax-free holding limit, and introduces an indefinite tax-exemption period to replace the old 5-year limit. We deem these developments and policies favourable to Japanese stocks.

Prefer domestically-oriented sectors, less affected by currency volatility; corporate reform to improve shareholder returns

The yen is fluctuating at a more than 30-year low against the dollar. On the prospect of the BOJ's path to normalisation and rate cut from the US, the divergence in monetary policy between the two countries will gradually narrow, inducing volatilities to the Japanese currency. This is why we believe domestic demand-oriented shares will not only be shielded from potential currency turbulence, the sectors are also more likely to benefit from Japan's reflationary regime, especially companies with strong pricing power, as well as IT firms that can offset labour shortage and improve efficiencies through digitalisation. The semiconductor equipment sector is also a beneficiary of escalating US-China tension.

Banks and financial shares are also on our radar, thanks to increasingly active financial activities on domestic and global fronts. On top of that, the unwinding of cross-shareholdings also improves corporate governance, bolstering the outlook of the banking and financial sectors. Listed Japanese companies are used to having low shareholder returns and inefficient capital allocation. Large Japanese companies have the custom of strategic shareholdings in each other to prevent hostile takeover. But such a move stifles operational efficiencies. To enhance corporate value, Tokyo Stock Exchange introduced corporate reform last year, demanding companies that are trading at P/BV of 1x to come up with solutions that will boost capital efficiencies and improve shareholder returns.

As of today, many firms have already rolled out plans of bolstering balance sheets, improving corporate governance, buying back shares or increasing dividends. As companies make inroads on reform, we believe the outlook for Japanese equities can brighten further, thus increasing valuations. Japanese shares are currently hovering at reasonable levels.

As of end-April, the MSCI Japan Index (USD) was trading at a P/BV of about 1.61x and a P/E ratio of less than 17x. These levels are more appealing than the P/BV and P/E ratios of 3.26x and about 21x, respectively, of the MSCI World Index (USD).

Buoyed by steadily rising wages, monetary policy normalisation and corporate reforms, we believe Japanese equities have further upside, which could bring additional momentum to multi-asset portfolios while diversifying risks.