Japanese stocks set to remain attractive amid Nikkei's all-time high, weak yen

Japanese stocks are maintaining a record-breaking run this week, bolstering expectations that the central bank will soon end its negative interest rates policy that has weakened the yen and lured overseas investors.

The Bank of Japan (BOJ) has been following a policy of holding down interest rates to encourage consumer spending, in contrast to the sustained rate hikes by the US Federal Reserve for nearly two years to rein in inflation.

But their policy stances are likely to be reversed sometime this year as the Fed is expected to cut interest rates while Japan is likely to raise rates. If these expectations are realised, it would narrow the difference in rates between the two countries.

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The Nikkei 225 rose to a new all-time high on Tuesday for the third consecutive trading session to close at 39,239.52 while the broader Tokyo Stock Price Index (Topix) increased marginally to 2,678.46, its highest level in 34 years.

The Japanese yen has been the worst performer among major currencies so far this year, losing 6 per cent against the US dollar. It was recently trading at 150.23, near its post-1990s low of 152 to the greenback.

Foreign investors have taken advantage of the difference in interest rates - such as those holding onto US dollars - by scooping up stocks of Japanese companies. The strong earnings growth of Japanese listed companies, which are at attractive valuations, has further boosted investor demand.

Moreover, Japanese stocks are likely to remain attractive as Tokyo is pushing for corporate governance reforms that are likely to unlock more value, analysts say.

Global supply trends are also favouring Japan as more international companies look to diversify away from China and boost their capabilities in strategic sectors such as semiconductors including expanding their links with Japanese companies.

"Japan is absolutely an interesting market that has been really overlooked and is now being rediscovered by many global investors," said Kei Okamura, senior vice-president at Neuberger Berman, a portfolio manager on the Japanese equities team.

Large caps, or companies with high market capitalisation, have led Japan's stock market rally thanks to their improved profitability as a result of the weaker yen, particularly export-oriented companies. Foreign investors driving the rally have focused on familiar names, said Emily Badger, Portfolio Manager at Man GLG.

Sumitomo Mitsui Financial Group, which is up 20.5 per cent year-to-date, rose 2.54 per cent on Tuesday while UFJ Financial Group, which is up 25.43 per cent year-to-date, gained 1.42 per cent on Tuesday. Both stocks gave the biggest boost to the Topix on Tuesday.

There are still plenty of bargain deals in small and mid-cap stocks that have been overlooked by many investors, analysts say.

"The key to unlocking sustainable value in Japan is primarily linked to corporate governance reforms," said Daniel Hurley, portfolio specialist for emerging market and Japanese equities at T. Rowe Price.

Only about a third of the companies trading on the Tokyo Stock Exchange have announced plans to improve shareholder returns.

A recent RBC Wealth Management report said it expects more companies to free up capital and deploy it to improve returns. "By divulging company names and using peer pressure, we expect the Tokyo Stock Exchange will encourage more companies to announce plans [to] improve shareholder returns," it said.

According to Okamura, the real issue is for companies to let go of unprofitable businesses and scale up through takeover bids, among other measures.

"If properly executed, it will allow for Japanese companies to see much, much higher valuations going forward. This is something that we haven't seen in the last 30 years. And this is exactly why many global investors are now relooking," he said.

The stock rally started after the Covid-19 pandemic when Japan's economy showed signs of a return to inflationary pressures after having endured deflation for over two decades. The recovery in prices has enabled companies to pass on higher costs to consumers.

Japan's January benchmark inflation data released on Tuesday has fuelled further speculation that the BOJ is about to embark on its first rate increase in April since 2007. Analysts are hopeful that the positive outlook for Japanese stocks will not change even if the BOJ were to begin tightening rates.

The core consumer inflation eased for a third straight month in January at 2 per cent. But it surpassed analysts' expectations and is within the BOJ's 2 per cent target.

"After the recent bout of inflation, the country's deflationary mindset has shifted. A shortage of labour is putting upward pressure on wages and the Tokyo Stock Exchange's proposals for reforms are accelerating change within companies," said Chern-Yeh Kwok, deputy head of APAC equities and head of Japan equities at UK asset manager Abrdn.

"The fundamentals of many Japanese companies remain firm despite the challenging economic environment. These all bode well for the prospects of Japan's companies and its economy," he said.

Despite geopolitical risks and the possibility of weaker global economic growth weighing on investors, market participants are optimistic about the outlook for the earnings of Japanese companies. This has led to a virtuous cycle of higher consumer spending and feel-good sentiment, analysts say.

"With further change by the Bank of Japan and with a move towards an inflationary environment in Japan, we may well see a stronger yen and a stronger market in Japan this year," Man GLG's Badger said. The Topix is still attractive to foreign investors and is still not stretched even after the recent run-up, she added.

Investors are also bullish about domestic investments as the Japanese government recently revamped the Nippon Individual Savings Account (NISA) - a tax-free stock investment option for individuals - by expanding annual investment limits and granting tax exemptions.

More than half of Japanese households' assets are sitting on cash, which does not bode well for them in a rising inflationary environment but various measures by the Japanese government are inducing more money to come out of bank deposits, Okamura said.

"The first wave has been more in global equities. But in the last several weeks, as the Nikkei has been touching new highs, these domestic investors have now been looking at their home markets to invest," he added.

This article originally appeared on the South China Morning Post (SCMP).

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