Japan’s stock market surge: what’s next for investors?

In February of this year, the Japanese stock market finally passed its 1989 peak. This has been an important psychological hurdle for investors, putting years of deflation and disappointment in the rear view mirror. In reality, the benchmark Nikkei index has been making progress for a number of years as Japan’s economy has improved, and the government has pushed for reform in the corporate sector.

For investors, the question is whether this strength can continue, or whether the catch-up from the Japanese market has largely run its course. The answer is more complicated than it might initially appear.

Setting the scene in Japan

To date, the market gains have been dominated by the large index stocks. Many are significant exporters that have benefited from the weak yen, while the country’s banks have also benefited from a shift in monetary policy. Large swathes of the market have been overlooked, particularly among mid and small-cap companies, and growth-focused areas such as technology.

This has influenced which funds have done well. The top 25 funds in the IA Japan sector over three years* tend to fall into three main camps: the first are the index funds, comprising around one third. The second are funds where the currency is hedged, which have not felt the full impact of the depreciating yen. The final group are deep value funds that tend to find most opportunities among the larger companies.

At the other end of the scale have been the growth funds, and particularly those with high weightings in smaller companies. This is a more natural hunting ground for active managers, and a number of managers with very successful long-term track records have struggled relative to their peers in this environment, including Baillie Gifford, First Sentier (FSSA) and T. Rowe Price.

Does this suggest an opportunity?

Certainly, growth fund managers argue that valuations look compelling. Matthew Brett, manager of the Baillie Gifford Japan Trust, says: “In share price terms, we’ve seen many of our favourite companies going sideways or down for two or three years. Under the bonnet they’ve still often been growing their sales, growing the earnings. So, they’ve just become cheaper.”

Baillie Gifford has a long-standing view that this is where the exciting growth is concentrated in the Japanese market: “This is a long-term strategy we’ve employed for many years, but it doesn’t work for every year and every period. There is greater growth potential in this part of the market, particularly in the domestic economy. The population of Japan is static and it’s a wealthy country. You need a company that can take market share. That pulls us towards some of the internet companies, for example,” says Matthew.

He doesn’t see the same opportunities among the large-caps. The banks are solid, but the growth is unexciting. He feels the same about the car companies. Their funds focus on themes, such as digitalisation, automation and artificial intelligence. He adds: “For example, within this portfolio, longstanding holdings like Rakuten and Cyberagent. Both of these companies have huge numbers of customers and that gives them access to lots of data which is what is needed to feed AI models, to create differentiated services and product offerings.”

The Comgest Growth Japan fund has around a quarter of its holdings in the IT sector**. It is also seeing its holdings perform well, even if their strength is not reflected in share prices. Manager Richard Kaye says companies in the portfolio are delivering consistent and idiosyncratic profit growth. He gives the example of Recruit, which owns job search engine Indeed, which has outpaced market expectations. He adds: “Toyota Industries delivered and projected continued profit growth. Moreover, the company’s logistics automation and compressor businesses are winning share in already growing markets. Suzuki Motor pleased the market by forecasting profit growth in the upcoming fiscal year”

What about currency risk?

Against this backdrop, where to invest in Japan seems like an easy decision: invest in the companies that are seeing strong growth, which have been left behind in the recent rally and dodge the index heavyweights that look more expensive. However, there are caveats to this, with the Japanese currency a particular risk.

The yen has been in long-term decline versus the dollar. Many of the companies held in the growth portfolios are domestic in nature and struggle in a weak yen environment. The yen has remained stubbornly low – the recent move in interest rates hasn’t made a difference, nor has the turn in inflation.

Richard Kaye says: “The yen matters for the sector leadership inside the markets. The stuff that has gone up in Japan has been mostly exporters, and banks – because everyone is assuming there’ll be pressure on the Bank of Japan to raise rates. If the yen stabilises or goes up, then that whole sector leadership changes, away from exporters, towards small and mid-cap names, technology heroes. Japan has a lot of those and they will benefit.”

The only encouraging sign is that the yen briefly rallied in November and December last year after the Federal Reserve said it was likely to cut rates in 2024***. It is notable that the biggest falls in the yen have come in response to US interest rate hikes. This suggests the yen could rally if interest rates in the US are cut later in the year. Richard believes the narrowing of the ‘yield gap’ (the gap between US and Japanese government bonds) could make a difference.

Striking a balance

Investors don’t necessarily have to take a value or growth approach. Funds such as AXA Framlington Japan do not have a significant style bias. Manager John-Paul Temperley believes the Japanese market as a whole still has many compelling factors. His analysis shows that at the peak of the ‘Abenomics’ euphoria, around US$250bn flowed into the Japanese market. Current flows are around one third of that****. “There’s still plenty of room for allocations to move further into Japan.”

He also points out that much of the move higher in the Japanese market has not come from a re-rating of the shares, but from stronger earnings of individual companies. This also leaves further room for growth in the Japanese market today.

There are plenty of reasons to like the Japanese market, even after its strong rally. The real value may be in the small and mid-cap sectors and ‘growth’ parts of the market, but investors may be taking a risk on continued weakness of the currency. There are more balanced options for investors who would rather not take that risk.

*Source: FE Analytics, at 10 June 2024

**Source: fund factsheet, 31 May 2024

***Source: Reuters, 7 December 2023

****Source: AXA IM UK, 5 June 2024