Issue 39: Deep Dive—Japanese Stocks

Deep Dive: Japanese Stocks

In 2023, Japanese stocks shrug off 30 years of stagnation
The Nikkei 225 Index posted a total return of over 28% in the first half of 2023, putting Japanese stocks higher than they’ve traded since 1990, when sudden tightening by the Bank of Japan burst a bubble that had formed in the nation’s equity and real estate markets. Japan’s 1980s bubble had developed on the back of cheap money that fueled rampant speculation, but the country’s economy had experienced rapid growth in the years leading up to the market’s crescendo. In the aftermath of its 1990 collapse, Japan experienced what was referred to as its “lost decade”—but which has really extended over most of the last 30 years—characterized by anemic growth and relative stagnation for its stock market. With Japanese stocks’ recent rally, many are questioning whether Japan might finally be ready to break out of its doldrums.

Strong balance sheets forged through decades of conservatism
In fact, a lot has been happening during Nikkei’s long hibernation. When the bubble popped in 1990, Japanese corporations quickly transitioned from being massive borrowers to significant net lenders. Japan has since become notorious for a crippling brand of financial conservatism that reduced business investment, increased job insecurity for the nation’s workforce, and kept Japan from the growth its East Asian neighbors have enjoyed in recent years. Economic initiatives championed by the late former prime minister Shinzo Abe—dubbed “Abenomics”—famously aimed to address this issue by encouraging companies to spend their cash reserves through various incentives and deterrents. Abe’s program didn’t solve his nation’s problems directly, but it did result in Japanese firms building exceptionally strong balance sheets. That financial robustness helped Japanese companies to navigate the pandemic and cope with rising food and energy prices. With the yen weakening recently, its exports are more competitive and companies are posting earnings surprises left and right.

A sea change in Japanese corporate governance
It turns out that there’s good reason to be hopeful this year’s surge in Japanese stocks isn’t another flash in the pan. Another consequence of a weaker yen has been that, coupled with rising interest rates globally, non-financial companies in Japan have significantly boosted their net interest income adding to substantial cash reserves. Despite being on solid financial footing and flush with cash, however, Japanese firms have been reluctant to raise wages or repurchase shares. Indeed, the average TOPIX company has an equity-to-assets ratio of roughly 50%. That’s a very high number.

But this conservatism seems to be changing in recent years, which comes down to a transformation underway in the realm of corporate governance. As Japanese firms’ financial strength increased, those diamonds in the rough became increasingly attractive to foreign activist investors, pushing for companies to either reinvest or return capital unlocking Japanese stocks’ deep value. For the last few years, that has been reflected in rising stock buybacks (see below).

In 2023, the Tokyo Stock Exchange has upped the ante and imposed rules on listed firms, including measures to force companies with exceedingly low price-to-book ratios—a classic indicator of ‘value stocks’—to pay excess cash out to shareholders. In light of these pressures, Japanese share buybacks reached a record high last year and are poised to do so again this year.

Are Japanese stocks poised for a longer run?
With its deep value characteristics, potential currency tailwinds, and recently strong showing in terms of economic growth, Japanese stocks appear increasingly inviting to foreign investors. The country’s business cycle does seem to be somewhat out of step with the rest of the developed world, with Japan posting 2.7% GDP growth in Q1—and its PMI surging to 54 in June—just as the US begins to lose steam and Europe falls into recession. Tourism in Japan is making a big post-COVID comeback, though we expect the reopening boom for Japan still has more room to run, as the nation was also relatively late to ease pandemic-era restrictions. Even more importantly, the dual shocks of the pandemic and Russia’s invasion of Ukraine spurred inflation that provided Japan with a unique opportunity to conquer its decades-long deflation problem. In May, super core inflation in Japan—excluding food, energy, and housing—reached a four-decade high of 4.3%. There are signs of rising wage growth as workers regain lost purchasing power, with annual wage talks this year leading to the largest boost in workers’ pay since the asset bubble burst in 1990. In our view, all of these trends suggest Japan’s resurgence is the real deal.

Creative ways to play it: Japanese small caps
One final thing worth noting: amidst big foreign inflows and a massive rally in Japan’s equity indices, not all stocks have seen the same bounce. A recent breakdown by the Financial Times (see below), cut Japanese shares in terms of their universe, assessing price-to-book ratios among different subsets of stocks. Passive flows into Japan’s market have gravitated toward larger stocks favored by funds like the iShares Japan Value ETF, pushing prices of large caps up and making valuations a bit less attractive (though almost half that basket still trades at something less than 1x book value, which is pretty darned cheap, even considering potential distortions due to Japan’s idiosyncratic accounting standards). By comparison, in the full universe with market caps above US$25 million—heavily tilted toward smaller stocks—over 90% of stocks have a price-to-book below 1x, suggesting the recovery in valuations has yet to extend too far beyond the large caps. While smaller stocks are harder to trade, this price-to-book napkin math suggests Japanese small caps could be an interesting way to get exposure to Japan’s comeback.

Musings About the US Economy

Revisiting the inverted yield curve
Precise timing of the business cycle is a tricky thing, and it’s even harder to time markets’ reaction to changes in the macro environment. That said, for those looking at past cycles for hints on where the US economy is headed this time around, the yield curve is telling us the next few months could be quite interesting. We’ve often noted that observation of an inverted yield curve has been a strong signal, historically, that the US is headed for a recession. An inversion in the curve occurs when the Fed raises short-term interest rates rapidly above the neutral rate, defined as the rate that neither stimulates inflation nor increases unemployment. When rates in the near term climb as the Fed tightens conditions, investors often come to expect an impending recession will prompt the Fed to cut at some point down the road, such that longer-term rates decline. When long rates are lower than short rates, the usually upward-sloping yield curve becomes ‘inverted’ and slopes down. Below, we plot one version of the US yield curve ‘term spread’—the difference between the long and short rates—where the yield curve inverts whenever this spread goes below zero.

Putting some numbers to the historical data
With respect to timing, the yield curve has typically inverted about 12-14 months before a cycle peak. Given we’re just about a year past the yield curve’s first inversion in this cycle, the signal suggests significant risk of a recession by this fall—though the lag time between inversion and recession can vary widely, ranging from 7-25 months. The magnitude of an inversion is also significant. That’s because a larger gap between long-term and short-term rates (a more negative number in the plot above) indicates a tighter monetary policy. Along those lines, it’s easy to see that last year has witnessed the yield curve’s deepest inversion since the early 1980s. In light of this evidence, while nobody knows exactly when a recession might begin or how hard it could hit, we remain dubious of the contrary signal sent by stock prices, credit spreads, and equity market volatility, none of which seem to be pricing any recession at all.

Weighing more dovish data
So, with the yield curve apparently definitive on the matter, why is anyone still holding out hope for a soft landing? The dove’s case is made by the sheer strength of the US economy in the face of so much adversity, which has been truly remarkable. A prime example of that occurred last Thursday, when the US Commerce Department updated its Q1 GDP growth figure, significantly boosting the final estimate from 1.3% to 2.0%, on an annualized basis. That strong growth was driven by consumer spending, which increased at a pace of 4.2%, the fastest since mid-2021, with spending on durable goods surging by 16.3% and spending on services gaining 3.2%. Meanwhile, the US labor market remains hot, adding 339,000 jobs in May. With unemployment at an historical low, last Thursday’s weekly jobless claims decreased by 26,000 and continuing claims fell by 19,000, suggesting quick reemployment for job seekers. On the inflation front, CPI fell to 4% in May, down from last summer’s four-decade high of around 9%. The personal consumption expenditures (PCE) price index, perhaps a better measure of inflation the Fed worries about, ticked up by 0.1% in May, while services inflation, excluding housing and energy, increased modestly by 0.2% for the month—the smallest advance since last July. All of these numbers seem to be pointing in the right direction.

So, how do we expect this economy to land?
We remain of the mind that Treasury yield curve predictions—which ultimately stem from prices set by more sophisticated bond market participants—are more or less accurate on the likelihood of a recession. We don’t have to take it from the yield curve, though: In the Conference Board’s second-quarter CEO survey, released in May, a whopping 93% of top executives polled expected a US recession within the next year and a half. We’re with them, though we also agree with those surveyed that the most likely scenario is a relatively mild recession. For us, this comes down to Fed policy. Despite a favorable trend, inflation is still too high for comfort and will encourage further rate hikes. The apparent robustness of the US economy could ironically be exactly the thing to give the Fed confidence to continue increasing rates, adding to the risk of overtightening leading to a downturn by year end. To that point, speaking at the ECB Forum on Central Banking in Portugal last Wednesday, Fed chair Powell commented that “the only thing we decided was not to raise rates at the June meeting,” and that he “wouldn’t take moving at consecutive meetings off the table at all.” With more hikes likely on the way, even as past policy works through the economy, we have trouble imagining the US economy exits entirely unscathed.