Japanese equities finally win over foreign investors

Prompted by corporate governance reforms in Japan, a stable inflationary environment and structural changes to the labor market, some foreign investors are finally buying into the long-term potential of Japanese equities after seven consecutive years of falls in foreign flows.

Japanese equities have surged dramatically since the start of the year, with the Nikkei 225 up more than 30% year-to-date. That's a dramatic reversal of the index's performance in 2022, with a 9.4% loss. Sources said Japanese equity markets are now trading at levels last seen at the end of the 1980s.

The surge has been led by foreign investment, as cumulative net weekly flows into Japanese equities by foreign investors since the start of 2012 reached ¥5.9 trillion ($41.1 billion) year-to-date after a steady decline from its 2015 peak, according to the BlackRock Investment Institute.

Cumulative net flows from foreign investors into Japanese equities reached a peak in mid-2015 with ¥25.1 trillion of inflows, but fell consistently throughout the years, hitting a low of ¥2.9 trillion in outflows by the end of March this year, according to BlackRock data.

Despite compelling numbers relative to history, investors are split on whether the current surge marks the start of a long-term trend, or are another short-term, tactical play. What sources did agree on, however, was that significant improvements in governance among Japanese corporates can only be a positive thing.

BlackRock Inc., with $9.09 trillion in assets under management, wrote in a June 26 commentary that it was rethinking its modest underweight on Japanese stocks due to a more shareholder-friendly approach from Japanese companies and a loose monetary policy.

Additionally, T. Rowe Price Group, which has $1.35 trillion in AUM, is holding firm to its five-year capital markets assumption that Japanese equities will return 9.2% on an annualized basis, which is on a par with its forecast for overall developed markets equities.

But unlike in other developed markets, investors have welcomed Japan's accommodative monetary policy as the country has struggled with economic growth over the past three decades, with GDP growth and inflation often dipping into negative territory.

The Bank of Japan is the last central bank to hold onto unconventional monetary policy of negative interest rates, and T. Rowe Price executives are not expecting them to change their interest rate policy, said Thomas Poullaouec, head of multiasset solutions, Asia-Pacific, in Singapore.

The BOJ kept its benchmark interest rate at -0.1% even as inflation reached a 42-year high of 4.3% in January, although it did relax its yield curve control policy by widening the tolerance band of its 10-year government bond yield. The inflation rate moderated to 3.2% in May.

In addition, the earnings growth potential driven by a corporate governance focus and "the use of cash by companies are really the key pillars of our overweight," Mr. Poullaouec said.

The Tokyo Stock Exchange has called for better disclosures and shareholder returns from companies, particularly those trading below book value, prompting an increase in cash spending on share buybacks and business growth.

"There's really been an improvement in dividend payout, which is now higher than in the U.S., and we have also seen a high level of share buybacks compared to other markets," Mr. Poullaouec added. Dividend payouts by Japanese companies are expected to reach a record high of ¥15.2 trillion by March 2024, ¥100 billion more than the year prior, according to a Nikkei Inc. analysis.

"The recent Tokyo Stock Exchange initiative is a game changer that builds on prior corporate governance reforms and focuses on improving underlying corporate profitability," said Oliver Lee, Singapore-based client portfolio manager at Eastspring Investments, which has $221 billion in AUM.

"And with higher levels of inflation and corresponding wage growth coming through, Japan also has the best chance in a generation to move out of its deflationary mindset," he said.

The average monthly wage for full-time workers in Japan grew 1.4% in 2022 to ¥311,800, the biggest increase since 1976. The wage gap between men and women narrowed in 2022, as average wages for women increased by 2.1%, while that of men rose by 1.4%. However, women's wages are still on average 24.3% lower than men's.

"You're going to suddenly have people with more money than they are used to, and they will have to spend because the inflationary pressures are pushing prices higher," said Martin Schulz, senior vice president, senior portfolio manager and head of the international equity group at Federated Hermes. The Japanese government has also pushed to have more women and the elderly in employment, he added.

Structural changes in the labor market, including wage growth, are among the reasons that Cleveland-based Mr. Schulz believes the recent surge in Japanese equities marks the start of a long-term trend.

Japanese assets currently make up 18% of his portfolio, up from 16% six months ago, and notably higher than the MSCI ACWI ex-U.S. benchmark set at 14%.

He admits that there have been moments over the past 25 years where foreign investors have gotten hopeful, then disappointed, about the resurgence of Japanese equities, but he believes this time is different.

"Could this be a short-term blip like we've seen in the past? Yes, for sure," he said. "But we do see signs at play that because this has gone on for so long, and (there are) factors (such as) external shocks from an inflationary side, that we do think this has some legs."

"Unlike past periods, you do have a fairly committed Bank of Japan," he added.

Federated Hermes has $701 billion in total managed assets.

One senior executive at a Japanese asset manager, who spoke on condition of anonymity, is less optimistic, however.

A weak Japanese yen and low interest rates have made fixed assets such as property appealing to institutional investors, he said. And Japanese equity has received attention after stock prices of the five Japanese stocks owned by Warren Buffet — Itochu Corp., Marubeni Corp., Mitsubishi Corp., Mitsui & Co., and Sumitomo Corp. Group — more than doubled since Berkshire Hathaway's disclosure that he owned the assets in 2020.

However, some investors aren't sure which stocks to buy, so they buy exchange-traded funds, which increases flows. "So it's more of a short-term or value play instead of a long-term play," he said.

Japan is also reaping the rewards of a post-COVID-19 recovery, having reopened its borders only in October, he added.

That the reopening trade in Japan — in particular due to the dropping of its indoor face-mask mandate in March — is also the reason for James A. Lydotes, Boston-based deputy CIO and head of equity income at Newton Investment Management, owning "zero names in Japan right now" in the firm's global equity income strategy.

Mr. Lydotes was in Tokyo in March, right before the recommendation to wear face masks indoors was dropped, and "while I can see the benefits of a 'reopening' trade that is coming two years after it came in other areas that had dropped mask mandates, Japan's economy was not really shut down." Restaurants were full, workers were returning to the office "at a pace which didn't seem that different from what we see in the West." Mr. Lydotes was surprised by how reopened the country already was.

"There will be some bumps with the additional feel of mask freedom, but I think we've already seen a good deal of the recovery that a lot of investors feel is still on the come-up," he said.

With equities now trading at levels not seen since the end of the 1980s, "it's hard to argue that a good deal of this enthusiasm is not already reflected in valuations," Mr. Lydotes said. And long-term challenges remain for Japan, such as demographic issues. While he said the reopening trade "will likely mean a tailwind to corporate earnings for the balance of this year, 2024 will start with all of the same headwinds facing the economy prior to COVID."

However, he added that there will remain "select opportunities ... because Japan does remain a technological center of excellence, but it's tough in my estimation to make a very aggressive positive call on Japanese equities."

However, owning no Japanese equities right now in the strategy "won't be long term, it's tactical, and we are looking — in fact, I recently met with an analyst where we discussed a potential new idea for the strategy in Japan. But as of right now, we have no weight there. We've owned Japanese names in the fund in the past, and own Japanese equities more broadly at the firm," Mr. Lydotes added.