The tide is finally turning for Japanese stocks

It took 33 years – longer than almost all fund managers have been in the industry, and indeed longer than some of them have been in their lifetimes. But finally, the Japanese stock market is coming back to life.

Of course, the question is whether this will lead to disappointment again for the unfortunate international investors. In this regard, one of the most important things to watch is the yen.

The country’s Topix stock index continued its slow and steady climb this week, hitting its highest point since August 1990. It’s still nowhere near the dizzying heights it hit in the epic Japanese asset bubble of the late 1980s—it has a cool 25 or so percent to go before the market returns to its peak.

Nevertheless, the market has not been operating in this area since then Turtle Power topped the UK pop charts. (If that doesn’t mean humming “Teenage Mutant Ninja Turtles” to yourself all day, then good taste, geographical distance, or youth must have protected you from this pop aberration.)

Japanese indices are among the world’s best-performing national benchmarks this year, with the Topix up nearly 14 percent and the Nikkei 225 up 18 percent. This towers over the nearly 10 percent gain in the American S&P 500. and it’s holding its own in another rare surge in Europe – the Euro Stoxx 600 is up 10 percent, but France and Germany could still beat that, at around 16 percent and 17 percent respectively.

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Giving the rally extra durability, it comes from a number of sources, including an accelerating corporate governance overhaul, a determined effort to clear up puzzling corporate cross-shareholdings, and a whole lot of ‘no’s. Japan is of course economically sensitive to post-closure China, but it is not China, so it does not sit under the same geopolitical or regulatory shadows.

Nor is the United States, which is alarmingly dominated by extraordinarily high valuations of tech stocks. Fun fact: Apple is now worth more than the Russell 2000 index of smaller US companies. Some investors are scared off by this level of concentration and attracted by Japan’s relatively low valuation.

This is great news for long-suffering Japanese market pundits who have been waiting for a comeback for years. Yes, the S&P 500 was up about 1,000 percent in the time it took for the Topix to finally return to 1990 levels. But many investors are understandably excited, and few dare to utter the words “it’s different now.”

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London-based Eddie Cheng of U.S. asset manager Allspring Global Investments is bullish on Japanese stocks. He likes the still-cheap valuations and the country’s low equity index weighting in sectors that have struggled globally of late, especially banks.

Topix trades at a combined price of 16 times its trailing 12-month earnings, compared to 20 times for the S&P 500 and 18 for the MSCI World Index.

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However, he describes himself as “much more cautious” in the medium term. For him, the main reason Japanese stocks have done well recently is the huge gap in monetary policy between Japan and pretty much everywhere else.

The U.S. Federal Reserve, the Bank of England and the European Central Bank have all launched historically aggressive rate hike campaigns over the past year, while the Bank of Japan has stood quietly and alone, keeping rates pegged to the floor and buying government bonds. to keep yields under strict control.

Among other things, this pushed the yen to its weakest level in the last two decades. The dollar has retreated from a 150+ year high reached in late 2022, but is still around 138. This makes Japan more advantageous for overseas investors.

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There is a risk that the spread could narrow if Japanese inflation turns out to be tougher than the BoJ expects, and if a US recession forces the Fed to cut interest rates. Both are big ifs, but both are acceptable results. If they materialize, the pillar of yen weakness that has played a big role in the rally in Japanese stocks could quickly collapse. The yen also serves as a typical safe-haven currency, so the risk of a US default could easily boost it.

Investors also point to another potential drag: What if the corporate governance overhaul becomes a victim of its own success? According to one fund manager, Japanese authorities could easily get what he calls the “heebeejeebies” — or the alarm goes off — if big foreign companies take advantage of the weakening currency and improved Japanese corporate governance to snap up companies on the cheap. “That’s the biggest fear, that it’s too soon,” he said.

All this may reflect excessive caution among fund managers, who are looking for a reason to be nervous. Even if the BoJ were to tighten monetary policy, for example, it would almost certainly be a long, slow process, rather than a sudden shock that sent the yen soaring. But hunting for problems is perhaps inevitable after so many false dawns.

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