Japan - Can the Recent Equity Rally Continue?

• Japan has been a tough market for investors – with uneven historic GDP growth, deflation and low corporate productivity
• Prior government policies (Abenomics) and recent initiatives by the exchanges are starting to show tangible progress
• Given the strong performance in 2023, how should investors think about Japanese stocks?

Background

From 1980 to 1990, GDP in Japan grew at an average rate of just over 4% and inflation averaged about 2.6%, contributing to strong equity performance. In fact, in 1990 eight of the ten largest public companies in the world were Japanese. This high-growth/lowinflation environment drove asset prices to such levels that in 1990 the Bank of Japan (BOJ) aggressively increased short-term interest rates in an attempt to slow the growth. The central bank’s credit tightening essentially popped the asset bubble and began an economic unraveling that lasted approximately two decades, characterized by inconsistent economic growth, deflationary trends and overly conservative balance sheet management by corporations.

Abenomics

In late 2012, understanding the country’s trajectory was unsustainable, Prime Minister Shinzo Abe presented his economic vision for the country (“Abenomics”), a comprehensive policy package with “three arrows;” aggressive quantitative easing, government spending programs, and initiatives to improve corporate culture and governance. Abe’s third arrow, arguably the most complex of the three, tackled the deeply rooted corporate culture and weak governance practices. Japan has made progress in this area as evidenced by recent efforts to increase independent board member representation.

Efforts by the Bank of Japan (BOJ)

As part of Abe’s quantitative easing arrow, the Bank of Japan implemented a Yield Curve Control (YCC) program in 2016 after the central bank aggressively cut short-term interest rates to combat an unwelcome strengthening of the Yen. At the time, the goal of YCC was to artificially suppress long-term interest rates and keep pressure on the Yen to ease financial conditions and stimulate economic demand for companies in Japan. The interest rate cut collapsed yields across the entire yield curve, reducing the attractiveness of longer term holdings, which in turn further drove investors to hold cash or seek yield outside Japan. Today’s improving-growth/moderate-inflation environment has significantly reduced the need for stimulus, potentially clearing the way for interest rate normalization.

Initiatives by the Exchanges

In early 2023, Japanese exchanges announced their own set of initiatives to address low equity valuations, identifying publicly traded companies that were inefficiently managing their balance sheets, as evidenced by stocks with price-to-book (P/B) ratios below 1X. These low valuations are partly due to high levels of cash on balance sheets, which results in low yields and inefficient returns on capital. Approximately 39% of Japan’s TOPIX 500 stocks recently traded at a P/B ratio <1X, compared to the S&P 500 where the comparable figure is 5%. The Japanese stock exchanges now require companies in this valuation category to either improve their price/book ratio or show progress toward improvement, otherwise they are subject to potential de-listing from the exchanges.

Are the Initiatives Working?

In 2023, Japanese companies put excess cash to work by either increasing stock buybacks, increasing dividends, or investing in capital projects. Since 2017, announced share buybacks on the TOPIX have been generally increasing each year. From an improving governance perspective, the number of companies whose board of directors was represented by at least 1/3 of independent directors rose from 6% to 92% from 2014 through 2022. Efforts to reduce cross-share ownership between companies are now underway, a move that could help unlock equity value. These developments have provided a tailwind for equities as Japan’s TOPIX posted a 2023 return of 28.2% in local currency terms (19.3% in USD terms), ahead of the S&P 500, which gained 26.3%.

Concluding Thoughts

Starting with Abenomics more than a decade ago and the more recent initiatives by Japanese stock exchanges, the tangible changes in Japan are attracting investors once again. The degree to which corporate managers in Japan will embrace corporate reforms could differ, resulting in dispersed equity performance going forward. Investment opportunities will likely vary by company, by sector, by equity style and by market capitalization. The relevance of Japan lies in its 22.8% weight within the MSCI EAFE index (developed non-US equities). Accordingly, ACG believes implementing Japanese equity exposure through active non-US managers is the most prudent approach and provides the best opportunity to capitalize on the changing investment landscape in Japan.