This month saw the Bank of Japan (BoJ) raise its main interest rate from 0.75% to 1% – the highest rate since 1995, in response to surging global energy prices due to the Iran war.

While Japan’s inflation rate has sat below its 2% target all year – it was 1.5% in May – a BoJ policy statement suggested a risk of it accelerating above that target, forcing businesses to pass on higher costs. This could lead to “an increase in consumer prices across a wide range of items”.

Widely expected by the market, the rate hike – decided by a vote of seven to one board members – was seen as a landmark step on Japan’s continued path towards ‘normal’ monetary policy, breaking out of a three-decade-long deflationary period.

Just one dissenter, dovish new recruit Toichiro Asada, voted to hold rates.

Economists and policymakers are described as ‘hawks’ or ‘doves’ depending on their approach to achieving economic stability. Hawks favour price stability and curbing inflation through tighter policy (rate hikes), while doves prefer economic growth and maximising employment through looser policy (rate cuts).

A summary of opinions from the bank’s two-day Monetary Policy Meeting (MPM) on 15-16 June was published by the BoJ last Wednesday (24 June). It doesn’t attribute quotes but cited one member as saying: “Raising the policy interest rate could suppress aggregate demand by curbing firms' business fixed investment, potentially inducing simultaneous declines in inflation and in production and employment. The Bank should therefore hold the rate steady at this point.”

Most of the opinions warned of mounting price pressures as businesses passed on the rising costs resulting from the weak yen and Middle East conflict.

What does the BoJ’s rate hike mean for Japan’s economy?

As Japan is an importer of natural resources, a weak yen pushes up the cost of imports for its domestic consumers and businesses, in turn fuelling higher inflation.

The yen is currently its weakest against the US dollar since 1986. Macrotrends data shows it was trading around 161.70 on 27 June, with traders braced for the possibility of further government intervention to prop up the currency.

Normally, if the BoJ hikes rates, the yen should get stronger. But according to Alex Hart, investment specialist at fund manager Sumitomo Mitsui DS Asset Management, that’s not happening right now because of the influence of the US.

He explains how people expected the US economy and job market to slow down, which would have led the Federal Reserve to cut rates. But economic revisions have held up – employment data was positive and inflation remains sticky – so a US rate hike may be expected instead.

Hart says this is weighing on the yen in terms of the attractiveness of the ‘carry trade’ (when investors borrow yen cheaply to invest in higher-yielding assets elsewhere).

“At the moment it’s probably more the US and global economy that are the determinants of the yen [as well as] real money demand,” he adds. Higher inflation is also encouraging Japanese consumers to buy more equities – selling yen and buying global assets. That creates additional downward price pressure on the yen.

That said, he doesn’t expect further yen depreciation because the government will likely intervene, which even if it doesn’t work it sends a message to hedge funds that might be looking to short the yen, for example.

Currency intervention is when a country’s authorities – in this case, the BoJ and Ministry of Finance – tap their huge reserves to sell US dollars and buy their domestic currency (yen), strengthening the local currency to help stabilise rising prices.

Many investors are waiting to see how all this affects liquidity, says Scott Gardner, investment strategist at investment platform J.P. Morgan Personal Investing.

A more ‘liquid’ market means consumers and businesses can spend, borrow and invest more easily, fuelling economic activity.

Where are the bright spots for investors in Japan?

Although the BoJ is slowly reducing its quantitative easing (QE) and bond-buying programme, Japanese banks are increasing lending and, in turn, their balance sheets.

“The commercial banks have been producing loads of liquidity, even more yen that has got to find its way into the market,” Gardner adds.

His team at the platform has been overweight Japan since the start of the year in its Fully Managed range, which is constructed using exchange-traded funds (ETFs).

“We like the Japanese economy and see overall economic activity improving, you’ve got the [aforementioned] liquidity picture and also a very pro-growth agenda coming from the Takaichi government,” he says.

Elsewhere, Hart says energy infrastructure-related stocks have performed well, while banks, consumer names and defence look promising.

“Some defence-related names have sold off quite considerably amid global expectations the war is ending. Also heavy aerospace, ships and tanks are being replaced by cheaper drones,” he says.

“But defence spending in Japan has increased to 2% of GDP – potentially moving higher than that. We’re seeing increased spending in other countries as well, also some of those names are now moving into drone technology, so that’s an area I think remains quite a bright spot in terms of its potential.”

Two of Japan’s biggest listed defence contractors are Mitsubishi Heavy Industries (TSE:7011) and Kawasaki Heavy Industries (TSE:7012). Both are listed on the TSE and investing in drone and unmanned aerial vehicle (UAV) technology.

Why invest in Japan?

The other exciting shift in Japan’s investment case, is its move away from a “sleepy giant of mainly industrials and financials” to a technology leader that’s holding its own alongside the rest of Asia.

“Semiconductors are the big thing at the moment, which plays into the index concentration dynamic you also see in the US. Around 21% of the Nikkei 225’s top 10 holdings are in semiconductors,” Gardner adds.

“The AI trade is in full swing across Asia; be it Taiwan, Japan, Korea… that's one of the reasons why the Nikkei has held up quite well relative to global market conditions.”

While most of the big tech beneficiaries are US-based, he sees the AI trade broadening because those further back in the supply chain who are actually responsible – “the picks and shovels”, as he describes them – are predominantly in Asia.

Hart also points to the tech theme; he says earnings growth is coming largely from data centres, with high levels of capex in electronic components.

Auto giant Toyota (TSE:7203) was Japan’s most valuable listed company by market capitalisation (market cap) for 20 years, holding the top position on the Tokyo Stock Exchange (TSE) before it was displaced by communications company SoftBank (TSE:9984) at the beginning of June.

Now in pole position on the TSE is computer memory manufacturer Kioxia Holdings (TSE:285A).

There is currently a ‘bottleneck’ in NAND flash memory (the type used in memory cards, USB sticks and SSD drives) and Hart says Kioxia (which spun out of Toshiba in 2018) is a pure play on that market.

How should you invest in Japan?

Investing passively in Japan right now is a big play on technology. For investors in index funds understanding the construction of the underlying index is crucial, especially if you’re looking at Japan to add diversification – you might end up doubling down on technology exposure.

The iShares Nikkei 225 UCITS ETF (LON:CNKY), which tracks its namesake index, has an approximately 40% weighting towards tech as of 26 June.

“The Nikkei 225 is share price constructed, which is one of the reasons why Advantest and Tokyo Electron are dominating the Nikkei. In the MSCI, they each make up less than 3%, so it’s a huge discrepancy,” Gardner points out.

It’s possible to invest directly in Japanese shares on some platforms, but this typically comes with restrictions, such as higher minimum investment amounts (Saxo) or having to give instructions over the phone (AJ Bell).

For more diversified exposure to the broader Japanese equity market, actively managed funds can cast their net wider.

Japan has around 4,000 listed companies, while even the TOPIX only has 1,500 names.

“Most of the inefficiency in terms of market pricing – given poor sell-side analyst coverage and so on – is potentially more exploitable with smaller and less-known companies, which active management can find,” says Hart.

Baillie Gifford Japanese is a growth-focused fund that invests in large and medium-sized companies with high and sustainable growth potential, while Man Japan CoreAlpha is another popular choice.

If you prefer closed-ended funds, some specialist investment trusts include J.P. Morgan Japanese Investment Trust (LSE:JFJ), Schroder Japan Trust (LSE:SJG) or AVI Japan Opportunity Trust (LSE:AJOT).

For broad Japanese index exposure, any of the major index fund providers likely have a Japanese equity offering at relatively lower cost, such as iShares Japan Equity Index or Vanguard Japan Stock Index.

Japan makes up around 5-6% of the global stock market (the second-largest regional exposure after the US), so indirect access via any number of global model portfolios or tracker funds will provide some exposure to the region.

Japanese shares hit a new all-time high earlier this month, with the Nikkei 225 index up 15% this year, outperforming the Topix index, which is up 9%. The performance gap between the two indices has spiked to the highest level in records going back to 1970, says Leo Lewis in the Financial Times. The Topix, which is weighted by market capitalisation, gives a more accurate picture of the broad health of the Japanese market.

The Nikkei 225, while more famous, is less accurate as it is weighted by price and tracks only the large-cap stocks. The latter's outperformance reflects strong buying enthusiasm from foreign investors for a handful of large-cap technology firms such as SoftBank, Tokyo Electron and Advantest.

While the technology names overheat, there is reason for optimism about the broader market. Corporate profits are picking up as the country exits years of “economic stagnation”, says a note from Asset Management One International. Pro-shareholder reforms are raising capital efficiency. Over the past 15 years, average return on equity for Japanese shares has been 8.14%, but that is on course to rise to 10.5% this year.

There is more juice to be squeezed yet from corporate reforms. On a price-to-book ratio of 1.77, Japanese shares still trade at a notable discount to the 2.32 level of their UK counterparts, not to mention the 5.14 level of US shares.

Japanese shares surge but bonds rise too

Prime minister Sanae Takaichi won a landslide victory in February on populist spending promises. This week, it was reported that Takaichi's government is preparing a supplemental budget to pay for rising costs caused by the blockage of the Strait of Hormuz – Tokyo is heavily subsidising petrol prices.

Heavier Japanese government borrowing increases competition for the limited global supply of loanable funds. Japan has historically been a major exporter of capital through the carry trade. Now those funds are being pulled back home, depriving other finance ministries of a key source of demand for bonds. Japan's ten-year bond yield has hit its highest level since 1996.

At around 206% of GDP in 2024, Japan's gross public debt is the highest in the developed world, says Shigesaburo Okumura for Nikkei Asia. The OECD think tank's latest survey of Japan criticised its “populist fiscal management”. The report notes that, at 10%, Japan's sales tax is low and could be raised to help balance the books. But Takaichi says cutting the tax is a “long-cherished wish” – a wish thwarted by the country's supermarket payment systems, which aren't set up to charge the 0% rate on food she desires.

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The Chinese don’t seem keen on Sanae Takaichi, Japan’s new prime minister. According to Bloomberg, “thousands of Chinese travellers” are reconsidering trips to Japan in the wake of her comments that a crisis in the Taiwan Strait would be an issue for Japan’s own security.

They are in a minority. Across much of the rest of Asia there is a general view that a stronger Japan is a good thing for the region.

With the US a less certain ally than in the past and China increasingly aggressive – both economically and in the South China Sea – a Japan with firm opinions and defence spending at record levels no longer seems like a bad thing.

Domestically, too, Takaichi is exceptionally popular.

Her supermajority gives her, in theory at least, the ability to do pretty much anything she wants. That’s particularly the case given the breadth of her support.

There is an idea that her election is a function of an increasingly right-wing ageing population. Not so. She has strong support from the over-50s, but exit polls showed she is popular among the under-30s, too. She definitely has a mandate.

So what’s she going to do with it? Good things – if the money pouring into Tokyo’s stockmarket is anything to go by.

Long-term readers will know we have been bullish on Japan for well over a decade.

But pretty much everyone has now jumped on our bandwagon. Being all in on Japan is now a consensus.

The Nikkei is up 9% so far this year – and surged to a record high in the few days after Takaichi’s victory.

A large part of the excitement is about political stability. There aren’t many democracies at the moment where a leader can say they have been elected so firmly and with such a clear set of policies. It is also about those policies.

Japan’s long-term problem has been lack of investment. The low growth rate in Japan's economy over the last 20 years or so has been in part about a lack of investment – a decline in the capital stock.

This is why Takaichi’s budget for 2026 had spending rising by 6.2%, and a $135 billion stimulus package passed (and will now be enacted) in November last year.

That fiscal expansion is to be connected to an industrial policy that pushes capital towards AI, semiconductors, quantum computing, defence and shipbuilding.

Expect a clear tailwind for all these sectors – and some healthy growth and inflation ahead, even without China’s tourists.

Two not-so-nasty headwinds for Japan's economy

There are – or so we are told – two nasty headwinds for Japan's economy: its whopping public debt levels, and its falling population.

The first is probably overhyped.

Government debt is running at 230% of GDP. But it isn’t the whole story. Japan’s government sector as a whole owns financial assets worth a whopping 140% of GDP (net net, that already takes Japan to a lower ratio than the UK). And this doesn’t even include the Bank of Japan’s holdings, which are about half of all the Japanese government bonds (JGBs) in issuance.

It does include a lot of domestic equities and deposits, and foreign-exchange reserves held by the ministry of finance.

Do the maths, says Gavekal Research, and you will see that it is all kind of fine.

The government pays around 1.5% of GDP out in interest on outstanding debt – an effective interest rate of around 0.7%. If the US foreign-exchange reserves of about 30% of GDP earn the Federal Reserve rate of 3.5% and the rest gets the Bank of Japan policy rate (0.75%) it all adds up to around 2.5% of GDP.

Look at it like that and “there is ample fiscal room to absorb higher debt servicing costs from existing resources alone”. Maybe there is nothing for the bond market to see here (until interest rates rise too much – that’s another column).

The second headwind also isn’t the problem you might think it is. The Japanese population has been falling for years and the working-age population started to decline a few years ago. But it coincides neatly with the rise of the technology required to replace people – AI and automation.

There is a huge space for automation in Japan.

One minor example: even in central Tokyo not all convenience stores have self checkouts.

On a rather larger scale there is plenty of room for manufacturing to go “dark”: Fanuc already has a factory that can run full time for 30 days with no human supervision at all (these factories are known as “dark factories” because robots don’t need lights during the night shift). Expect more of these.

At the same time, as the votes for Takaichi showed, the young are happy with things as they are. They don’t remember the deflationary years so well and they live in a world where they should inherit a couple of houses, where their wages and disposable income are rising fast (one popular company in Tokyo just put up new graduate salaries by 30%) and where everyone is nice to them. Being a scarce resource isn’t all bad.

The sharp rise in Japanese stocks suggests that much of the good news is priced in. That said, with rising flows as investors rotate out of the US it is perfectly reasonable to expect tech, industrials and defence stocks to maintain momentum.

There is also an excellent chance that, with the indices at all-time highs and the optimism following the election, Japan’s institutional investors will finally move some money out of fixed income and into equities, says Chris Wood of Jefferies. When that happens, the market will “rerate in terms of multiple expansion”.

Merryn Somerset Webb hosts the Merryn Talks Money podcast for Bloomberg. Find her on X @MerrynSW

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Japanese stocks have responded positively to news that its new prime minister, Sanae Takaichi, has won a landslide victory in the country’s snap election on 8 February.

Takaichi called the election soon after she took over as leader of the Liberal Democrat Party (LDP) in the hope of winning a sizeable majority to push through her economic agenda, which is likely to include more government spending in a bid to revitalise the country’s economy.

Calling the snap election was viewed as a gamble, especially given Takaichi’s indications that she would step down as prime minister if she failed to win a big majority. But the move appears to have paid off, with the LDP securing 316 out of 465 seats in Japan’s House of Representatives – the first time a single party has secured a two-thirds majority in the history of Japan’s present parliamentary structure.

Combined with its coalition partner, the Japan Innovation Party, the LDP secured 352 of 465 seats.

The win saw Japanese stocks rise, with the Nikkei 225 gaining 3.9% on Monday 9 February.

“The big story of the week is a remarkable landslide victory for Japan’s first ever female prime minister, Sanae Takaichi, and the ruling LDP party she heads,” said Tom Stevenson, investment director at Fidelity International.

“Takaichi was hopeful of a big win. But the scale of the landslide on Sunday surpassed everyone’s expectations, leaving Japan as a beacon of political stability,” Stevenson added.

What does Takaichi’s big win mean for Japanese stocks?

Takaichi, Japan’s first female prime minister, now has a mandate to put forward what is expected to be a robust pro-growth agenda for the Japanese economy.

“This includes expansionary fiscal spending and increased strategic investments in areas such as semiconductors, artificial intelligence (AI), energy security, defence and shipbuilding,” said Hisashi Arakawa, Head of Japan Equities at Aberdeen Investments. “There is also talk around suspending the 8% consumption tax, which would also help lift domestic consumption.”

“Industrial stocks were big winners, on hopes that strategic spending plans will boost key sectors,” said Stevenson.

Takaichi’s pro-growth program will coincide with a longer-running development in Japan’s stock market, namely attempts by the country’s Financial Services Agency to continue to improve corporate governance in the country.

This will see Japanese companies, which historically have tended to sit on large quantities of cash, become incentivised to return this capital to investors through reinvestment, dividends and share buybacks.

“We believe that the outlook for quality remains positive, with the market increasingly rewarding companies that can deliver sustainable earnings and adapt nimbly to a shifting operating backdrop,” said Arakawa.

What are the risks in Takaichi’s agenda?

While her gamble of a snap election has paid off, Takaichi’s move is not without risk as far as Japan’s economy is concerned.

The country has among the highest levels of government debt in developed markets, and fears that Takaichi’s economic program will add to that, especially given her new mandate, have seen Japanese government bond yields rise.

“Companies are wary of higher government borrowing and potential tax changes,” said Kate Marshall, lead investment analyst at Hargreaves Lansdown. “There are also concerns about labour shortages. Japan’s population is ageing rapidly and Takaichi has taken a tougher tone on immigration.”

In the last three months (roughly corresponding to Takaichi’s tenure as prime minister), yields on 10-year Japanese government bonds have increased from around 1.7% to over 2.2%, reaching as high as 2.3% on 9 February.

“Investors are watching developments closely, not just for the impact on Japanese assets, but potentially on other markets too,” said Stevenson. “Rising yields on Japanese government bonds make Treasuries [US government bonds] less relatively attractive and could trigger a repatriation of assets from the US to Japan. Higher Treasury yields, in turn, could have a negative impact on US shares, especially growth stocks whose present day value is reduced as bond yields rise.”

How to invest in Japanese stocks

Depending on the broker, some UK-based investors may be able to buy Japanese stocks directly. But most will prefer to invest via a fund or investment trust that focuses on the country.

For broad-based exposure to the Japanese stock market, investors could select a tracker fund like the Vanguard FTSE Japan UCITS ETF (LON:VJPN) or the iShares Nikkei 225 UCITS ETF (LON:CNKY). These track the FTSE Japan index (which is comprised of large- and mid-sized Japanese stocks) and the Nikkei 225 index (which consists of 225 of Japan’s largest and most-traded stocks) respectively.

The two largest investment trusts that focus on the Japan market (as of 9 February) are Baillie Gifford Japan Trust (LON:BGFD) and JPMorgan Japanese Investment Trust (LON:JFJ).

Japan’s politics are unstable, the yen is trading at multi-decade lows against most major currencies, long-term government bond yields have soared, and inflation is picking up again. Yet corporate Japan is doing just fine. Stocks are regularly reaching new highs and seem likely to continue upwards.

On a price/earnings ratio of about 16, the market’s valuation is at the top of its 10-year range but earnings growth is coming through strongly, says Masaki Taketsume, manager of the £370 million Schroder Japan Trust (LSE: SJG). The consensus for 2026 is for an average gain of 10%.

Rising interest rates, which are expected to reach nearly 2% over the next year, should benefit financials, he says. However, a weak yen means that exporters are expected to see most of the earnings growth. This is reflected in SJG’s portfolio of 60-70 stocks, which includes conglomerate Hitachi, Toyota Motor and electrical-equipment group Fujikura, as well as bank Sumitomo Mitsui and multinational insurer Tokio Marine as its largest holdings. There is a strong weighting to mid and small caps, which account for 47% of the portfolio, against 27% in the Topix index.

Gearing of 13% of net assets show Taketsume’s optimism. A five-year return of 78% (60% over three years) is one of the best of the mainstream Japanese equity funds. Still, the shares trade on a 10% discount to net asset value (NAV).

The record of the £315 million CC Japan Income & Growth Trust (LSE: CCJI) is even better, at 91% over five years and 67% over three. Yet it also trades on an 8% discount. Its top 10 holdings include video games giant Nintendo, engineering group Mitsubishi Heavy Industries (Japan’s largest defence contractor) and tech investor SoftBank. With just 37 stocks, the CCJI portfolio is more concentrated than SJG.

Investments in Japan return to form

Until 2021, JPMorgan Japanese Investment Trust (LSE: JFJ), with £1.2 billion of net assets, and the £916 million Baillie Gifford Japan Trust (LSE: BGFD) led the sector by a mile, but their strong growth bias brought them crashing down to earth. Subsequently JFJ, with a three-year return of 67%, recovered much more quickly than BGFD (38%). However, their one-year returns of 24% are similar and about 5% ahead of SJG and CCJI. These two also trade on a discount of about 10%.

The improvement is partly due to growth returning to favour but also to some much-needed portfolio reorientation. “We had a lot less in cyclical stocks, such as carmakers and banks, so grew more slowly coming out of Covid, but that has changed in the last year,” says Matthew Brett, manager of BGFD. “There are lots companies in Japan which aren’t growing any more so we are having to look away from the index at mid-cap and smaller companies.”

SoftBank is BGFD’s largest holding – its investments in Arm and OpenAI are key to the AI story, says Brett. Rakuten (e-commerce), CyberAgent (digital advertising) and Bengo4.com (online legal services) are also AI beneficiaries. Video games should also be helped by AI, allowing them to be developed faster and more cheaply: Nintendo, Sega Sammy and Square Enix are all in the portfolio.

Pharmaceutical company Eisai has – in partnership with Biogen – the first approved drug for early Alzheimer’s disease. Robotics, an area of national strength – “Japan has a pressing need to manage a declining population” – also features, with Fanuc.

SBI, Japan’s largest stock brokerage, is the second-largest holding. It should capitalise on the growing popularity of the enhanced Nippon Individual Savings Account (Nisa), a tax-free vehicle modelled on the UK ISA. “With inflation coming back, putting money into the bank isn’t so smart any more. Real estate and the stockmarket should benefit.”

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The good times are rolling again in Tokyo, where the Japanese stock exchange has extended its record rally, fuelled by what UBS calls the “Takaichi trade”, says MarketWatch. But if new PM Sanae Takaichi – the country’s first female prime minister – is one symbol of the boom, another is the return to prominence of one of Japan’s most notorious traders.

Activist investor Yoshiaki Murakami was a central player in the Livedoor scandal that shook Japan to its roots in 2006 when the internet company, founded by the flamboyant Takafumi Horie, collapsed spectacularly after the exposure of a shares and accounting scam. Eventually sentenced to two years for insider trading of shares in Nippon Broadcasting System (which Horie had waged a hostile bid to acquire), Murakami’s downfall was viewed as a “victory for Japan’s traditional business community”, who regarded his “brash brand of capitalism with barely concealed contempt”, noted The Guardian at the time.

Like Horie, Murakami had risen to prominence as an enfant terrible, determined to crush established hierarchies “in the search for quick profits”. Famous for “aggressive tactics and fiery language”, the impact of his disgrace – and the wider collapse following the 2008 global financial crisis – was to bring “activist investing in Japan to a halt”, says Bloomberg. In 2009, he left the country for Singapore to concentrate on real estate investments.

Now 66, Murakami is back with a new firm, City Index Eleventh, and his tactics haven’t changed – he spots weakness in a target and tightens the screws until he gets what he wants. The latest is another prominent broadcaster, Fuji Media Holdings, which in January became engulfed in a sex scandal. “Longtime executives quit in disgrace. Advertisers fled. Earnings cratered” – and Murakami piled in, amassing a 16% stake and demanding the spin-off of subsidiaries to boost the share price. Since his investments started picking up in 2021, his companies have made ¥170 billion (£841 million) in profit, according to Citic Securities. Indeed, Murakami, his family and affiliates now control at least £2.4 billion in Japanese stocks – two daughters, Aya and Rei, are in the business.

More significantly, the originator of Japanese activism has helped spawn a new movement. A record 146 activist campaigns were waged in the country last year, disrupting “once-clubby” executive suites and helping to revive Japan’s stock market.

After graduating from the University of Tokyo in 1983, Murakami joined the Ministry of International Trade and Industry – gaining a reputation for his financial acumen and straight talk. Murakami got into the habit of checking financial results before meetings and was astonished by how many executives were ignorant of the company’s balance sheet. They simply assumed the customary practice of their predecessors – sitting on hoards of cash rather than investing. “Frustrated by the lack of urgency”, he left the civil service, “figuring he could be more effective as an investor”.

Yoshiaki Murakami's Marmite personality

Something of a Marmite personality, Murakami is castigated by opponents for “using fear as an investment strategy”, says the Financial Times. Others view him as a brave standard-bearer. “He’s Japanese – with a thoroughly Anglo-Saxon understanding of capitalism,” one broker told Bloomberg. “He was an insider who realised Japan needed to change and became an outsider to make that happen.” Murakami’s “approach was direct, data-driven and fundamentally correct in diagnosing bloated balance sheets [and] weak governance”, adds Star Magnolia Capital. “Management teams saw him as an intruder”, and the media “portrayed him as a raider”. Yet he wrote “the first chapter of modern Japanese activism”. No doubt he plans to write a few more.

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After five years of miserable performance and with the shares trading at a 10% discount to net asset value (NAV), despite 20% of the share capital having been bought back, the directors of the Baillie Gifford Shin Nippon (LSE: BGS) trust have had enough. They have acknowledged the need for an immediate turnaround in performance and stated that if poor performance continues, they will explore “all available options”. This has been presumed to mean not just a tender for 15% of the share capital at a 2% discount in 2027, but also a possible change of manager and strategy.

In the last five years, the NAV has fallen 25% compared with a gain of 42% in the MSCI Japan Small Cap index, a 93% gain for the AVI Japan Opportunity Trust and 144% for Nippon Active Value. The question for BGS’s directors might be why they have been so slow to act. However, a study of precedents for changing managers and style is far from encouraging. The poster child for recent change was the switch in the management of Temple Bar from Investec Asset Management to Redwheel nearly five years ago. Since then, the investment return has been 148%, nearly twice the return of the All-Share index.

But the directors wisely decided that although they would change managers, the trust would continue to invest in “value” rather than “growth” stocks, even though the former had suffered terribly in the pandemic. Since then, value has far outperformed growth. It’s not obvious that the performance would have been too different had the previous manager, Alastair Mundy, been willing to continue to manage it.

Other changes, although ostensibly maintaining continuity of style, have been less happy. In 2021, the directors of Genesis Emerging Markets, tiring of Genesis’s pedestrian performance, switched to Fidelity. The new managers sought to inject some fizz into the performance with a disastrously timed foray into Russia. To its credit, Fidelity has since performed much better, so although the five-year record remains poor, three- and one-year performance is now good.

The board of Mid Wynd appointed Lazard as managers in place of Artemis in 2023, perhaps believing that its lead manager, Simon Edelsten, was about to retire. But Edelsten has since re-emerged at Harwood, alongside his former co-manager Alex Illingworth. Mid Wynd’s board probably thought that Lazard’s growth strategy, supported by a solid record, would provide the shareholders with continuity. Instead, the trust has returned just 10% since Lazard’s’ appointment against 35% for the MSCI AC World index. Lazards appears to rely on an inflexible process, while Edelsten and Illingworth made use of insight and flair. The board should hand the management contract back to them.

Have other investment trusts fared better?

Boards that switched not just manager, but also style, have fared no better. Keystone was once managed by the investment arm of S.G. Warburg, investing in UK equities. It shifted to Invesco in 2017 and thence to Baillie Gifford in late 2020, adopting a high-growth global mandate under the new name, Keystone Positive Change. Baillie Gifford’s style fell out of favour soon after, and Keystone was unable to bounce back. It was wound up earlier this year.

Schroders struggled to replace Richard Buxton as manager of Schroder UK Growth when he left for Old Mutual in 2013. Five years later, the board tired of Schroders’ failure to replace him with a quality manager and switched managers to Baillie Gifford. This has not been a success and the trust has dramatically underperformed the All-Share index in the last five years, although only moderately over one and three years. Perhaps “UK Growth” is just a contradiction in terms; in any case, time is running out.

MIGO Opportunities Trust moved with its managers from Miton to Asset Value Investors, but its lead manager, Nick Greenwood, has now retired and AVI propose a change of focus. Instead of investing in undervalued trusts, AVI now proposes a narrower, “activist” approach, seeking to compel companies it invests in to do something about the discount at which their shares trade. But this approach is expensive, time-consuming and often unsuccessful. Moreover, the time for it may have passed. Two years ago, discounts to NAV were wide, performances had flagged, but an upturn was imminent. Opportunities were plentiful, as Saba Capital realised. Now they are much scarcer and riskier. Hopefully, MIGO will continue as before.

It’s not all bad news. Edinburgh Investment Trust has found a stable home at Majedie and generated solid returns, while the shareholders of STS Global Income & Growth seem happy with Troy’s low-risk, modest returns approach. Trust mergers have generally been successful. Internal changes of manager, such as regularly performed at JPMorgan, have a good record overall, as has the ratcheting up dividends.

A change of management company and style, however, has a poor record. A new style is adopted and management company appointed when it is riding the crest of a wave. Then, the market changes gear, the new managers struggle and don’t have the embedded goodwill from past performance to carry them through difficult times. What, then, should the Board of BGS do? They need to recognise that smaller companies have performed poorly the world over in recent years. In Japan, the growth style has been heavily out of favour, which is why BGS’s two value-orientated rivals have left BGS trailing in the dust.

Yet BGS’s performance has picked up in the last six months while Baillie Gifford Japan (LSE: BGFD) has had a good year. It looks as if the growth style is returning to favour; if so, there is nothing to be gained and much to be lost from BGS changing strategy now. BGS could merge with BGFD, as JPMorgan’s Japanese Smaller Companies Trust was merged with JPMorgan Japanese, but better, surely, to give Brian Lum, BGS’s new lead manager, a chance to prove himself.

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The Japanese stock market is often overlooked and frequently misunderstood, but now could be the time to consider investing in Japan.

While DIY investors’ top stocks and funds typically have a more domestic and US tilt, many investors are looking for ways to diversify their strategies. This is particularly true of divesting away from the US in light of the various tariff-induced stock market selloffs this year so far.

Japanese equity performance, meanwhile, is in the process of a major overhaul thanks to a raft of corporate governance reforms from the Tokyo Stock Exchange. These reforms were initiated during the tenure of the late Shinzo Abe, who was prime minister of Japan from 2012 until 2020, and have been continued by his successors since.

“There’s basically a governance revolution going on,” says Nicholas Weindling, co-manager of JPMorgan Japanese Investment Trust (LON:JFJ).

Historically, Japanese companies have been significantly over-capitalised, with large piles of cash – sometimes billions of dollars’ worth – as well as real estate and other companies’ shares sitting on their balance sheet.

“All of that is changing,” says Weindling. “They have been told, really, by the government and Tokyo Stock Exchange that the return on equity is unacceptably low, it’s not right to sit with so much cash, and to do something about it.”

Japan is set to appoint its first female prime minister, Sanae Takaichi, who is a disciple of Margaret Thatcher as well as Abe, and also used to be a heavy metal drummer. Takaichi was elected as leader of the country’s ruling Liberal Democratic Party (LDP) on Saturday 4 October, and while the LDP no longer commands a majority in either house of the National Diet (Japan’s governing body), analysts think it is unlikely that opposition parties will block her from becoming prime minister.

“I think what [Takaichi] is known for is that she is a strong believer in Abenomics and that she is fiscally expansionary,” says Nicola Takada Wood, managing director, Japan at Asset Value Investors. “She believes in loose monetary policy, she wants to invest in sectors like defence and semiconductors and space.”

Corporate governance reforms could keep driving Japanese investments

The corporate governance reforms have been a major part of the recovery of Japan’s stock market in recent years.

“Every now and again, people get renewed enthusiasm for corporate governance reform and talk about it as if it’s something new,” says Richard Aston, portfolio manager of CC Japan Income and Growth Trust (LON:CCJI) and the Chikara Japan Income & Growth Fund. “The reality is, it’s been 12 years in the making to get here. But very importantly, it’s not over.”

Takada Wood echoes this view that corporate governance reform is just getting started.

“I don’t think we’re even a third or even a quarter of the way through what’s going to happen in terms of corporate governance reform,” she said, highlighting that the Tokyo Stock Exchange currently only thinks around 15% of Japanese companies are doing a good job when it comes to implementing reforms.

Aston argues that the corporate governance reforms can upend the usual dichotomy between growth and income stocks when it comes to Japan because some high-potential growth companies are now also in a position to increase their returns to shareholders. “Historically, these companies haven’t had this relationship with shareholders, and are now in a strong position to complement that return with distributions,” he says.

Japan's macroeconomic backdrop

Besides corporate governance reform there are other macro tailwinds blowing in Japan’s favour.

Having been caught in a deflationary spiral for decades, Japan has returned to inflation.

“People are saying ‘now inflation is too high’, but that’s because the Yen is so weak,” says Takada Wood. “It’s imported inflation. It’s energy and food – if you strip that out, it’s very healthy, around 2%,” she says.

It isn’t surprising companies and individuals err towards cash hoarding given this recent history of deflation. Under these conditions cash effectively appreciates in value over time.

“The average Japanese person has a 55% allocation to cash,” says Weindling. “In a deflationary environment, that’s a good decision.”

But this sustained period of inflation has started to change mindsets in Japan.

That has also coincided with a period of sustained wage increases, which had been flat for 15 years prior to 2020. This could lead to an uptick in consumption.

Weindling, though, makes the point that it doesn’t necessarily matter when deciding whether to invest in Japan because, similar to the situation for UK stocks, there is a big disconnect between the Japanese economy and the Japanese stock market.

“The Japanese economy hasn’t grown for 15 years,” he says, “but earnings per share growth in Japan over the last 15 years is the same as the S&P 500. That is incredible, because you’ve got the S&P re-rating up to ever higher multiples, while Japan with exactly the same earnings per share growth still trades on a very significant discount to that and other major markets as well.”

How to invest in Japan

Some platforms and brokers may give you direct access to Japanese stocks. If so, there are hundreds to choose from beyond the automobile and technology stocks that many investors bring to mind when they think about Japan’s stock market.

“Take something like ASICS (TSE:7936),” says Weindling. This is one of the world’s leading sports footwear brands and is familiar to many Western consumers, but many aren’t aware that it is Japanese.

Takada Wood picks out Rohto Pharmaceutical (TSE:4527), which she stresses is not a pharmaceutical company at all but rather Japan’s leading skincare and eye drop brand. “It’s really undervalued,” says Takada Wood, “because people value it as a pharmaceutical company, and it’s not.”

While you can attempt to pick your own Japanese stocks, investing via a fund or an investment trust is often a more convenient route to gaining exposure.

The three Japan-focused investment trusts featured in this article all provide different means of exposure to Japan via their investment strategies.

Asset Value Investors manages AVI Japan Opportunity Trust (LON:AJOT) which has a focus on activism with its investments, in keeping with Asset Value Investors’ broader strategy.

“We position ourselves as the management consultancy stance; we say to companies ‘we’ve analysed your company, we really like your company, we think you’re great at X, Y and Z, but you’ve clearly got issues in other areas, and that’s what’s keeping your valuation down.”

In this vein, AJOT has been working closely with Rohto, which has been overspending on so-called ‘growth’ areas that haven’t grown, and persuading management to shift attention back towards its core businesses where they have a dominant position and high margins.

Chikara’s Japan strategy, which underpins both the investment trust and the fund, focuses on companies and sectors that generate more stable returns, more stable cash flow and which have a chance to grow over time.

“We’re not necessarily an income fund,” says Aston, “in the way that people view income funds maybe in the UK, where a lot of the companies that offer high income are troubled or broken companies.”

JPMorgan Japanese Investment Trust is the largest dedicated investment trust with a market cap of over £1 billion as of 10 October. It has a presence in Tokyo, with 20 analysts on the ground in the city, and focuses on quality and growth.

“We’re looking for the best investments in Japan on a multi-year basis,” says Weindling.

As of 10 October, these investment trusts traded on the following discounts:

^{Source: Association of Investment Companies}

Global markets reacted immediately to Donald Trump’s election victory. Japan was no exception, with key indices enjoying a lift. While the initial impact will fade quickly, concerns over the pursuit of protectionist trade policies are set to linger. It is necessary to judge carefully how policies announced at the time of the election are actually implemented; how might they affect individual companies?

In this environment, mid-caps focused on the domestic economy – which are generally well insulated from external macro factors and beneficiaries of reshoring – represent attractive opportunities. Meanwhile, Japan-specific developments, such as reflation and corporate-governance reforms, are multiyear structural factors creating new investment ideas.

Where to invest in Japan

Miura (Tokyo: 6005) is a global leader in so-called once-through boilers, which offer superior energy efficiency. The company has an excellent business model based on the provision of contract-based maintenance services, which are conducive to recurring and stable profits. I have been impressed with the strategic changes that the company has implemented, particularly its efforts to reduce its dependence on the Chinese market and to broaden its product line-up.

Miura recently acquired a major player in the US, Cleaver-Brooks, which will provide a new growth driver for the firm. Following the US election, the issue of tariffs is likely to dominate headlines for months to come and it makes sense to hold reshoring beneficiaries such as Miura that can deliver stable earnings.

Ryohin Keikaku (Tokyo: 7453) runs the Muji brand of general merchandise stores and is a company I have actively engaged with for many years. Management is executing its strategy incredibly well and the business is generating double-digit growth rates at home and in China, where a combination of internal initiatives and macro factors are supporting a pick-up in demand.

In Japan, strong sales growth, underpinned by successful new products and price hikes, is leading to lower discounts and higher profit margins. At the same time, the reflation story in Japan, fuelled by a shift in price and wage-setting behaviour, is supporting a pickup in consumption that Ryohin Keikaku is well positioned to capture through new store openings and popular product lines. I expect the company to deliver double-digit profit growth through fiscal 2027. A forward price/earnings (p/e) ratio of around 13, excluding cash, leaves plenty of upside potential.

Sanrio (Tokyo: 8136) sells Hello Kitty and Friends merchandise and operates Hello Kitty theme parks, with around 70% of sales generated in Japan. Hello Kitty was created in 1974 and remains a popular and beloved character in Japan and globally, as evidenced by the inbound tourists that visit the company’s parks. Moreover, Sanrio is ideally placed to capture the structural growth of the Japanese character intellectual property (IP) market and its character diversification strategy is helping to reduce earnings volatility.

The company’s strategies in the licensing business are working very well in both North America and China, which are contributing to an improvement in overall profitability. Sanrio recently upgraded its full-year guidance and I expect it to deliver double-digit profit growth over the next two to three years, justifying its valuation premium.

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Japan’s ruling coalition lost its majority in its latest general election, throwing the country “into the kind of political instability not seen for decades”, says Adam Withnall in The Independent. Amid deep voter apathy – turnout was just 53.8% – prime minister Shigeru Ishiba’s Liberal Democratic Party (LDP) and its junior coalition partner Komeito ended up with 215 seats in Japan’s Diet, down from 279 and “well short” of the 233 needed to form a government. It is the worst result for the LDP, which has ruled Japan since 1955 with only two short breaks, since 2009.

A chastened Ishiba conceded that the result reflected ongoing public “distrust and anger”, say Tamayo Muto and Sayumi Take in Nikkei Asia. Since last year, the LDP has been “dogged” by a scandal in which senior party members were illegally given money for campaigning out of a secret slush fund. Ishida was elected party leader in September largely because of his promise to hold individuals accountable, and he called a snap election three days later to try to capitalise on his honeymoon period, says Julian Ryall in The South China Morning Post. Then, in the final week of the election campaigning, it was revealed that some of these individuals, who had been forced to stand as independents, were receiving party money anyway.

How will this impact markets in Japan?

Ishida also U-turned on a number of key policies, including creating an Asian version of NATO and supporting same-sex marriage, says Gearoid Reidy in Bloomberg. It’s hard to understand how such an experienced and popular politician could have made so many missteps. Ishiba is now saying that he does “not envisage forming a coalition” in the 30 days before the next Diet must be convened, indicating that he would “try to make deals for individual pieces of legislation” instead, says Richard Lloyd Parry in The Times. This will use up “considerable time, effort and political capital”, notes Ryall, and “paralysis” in the Diet will only erode his support still further. Hardly any investors seemed prepared for this “upset”, says John Authers on Bloomberg. Japan is “usually stable to a fault.

Instability changes its offer completely.” When the LDP last lost power in 2009, Japan went through three prime ministers from opposition parties in three years. If something similar were to happen now, it would be a “big problem” for Japan, which is trying to “manage the transition away from decades of inflation”. Despite the LDP’s “drubbing”, the structural reforms kicked off by former PM Shinzo Abe in 2012 are likely to continue to pay off, says Una Galani in BreakingViews. Of late, the Nikkei 225 has hit levels not seen for more than 30 years.

While politicians “bungle”, Japanese CEOs are likely to “stay focused on growing high-return businesses, offloading underperforming ones and shrinking the piles of assets on their balance sheets”. Japan’s next government may try to “shore up its popularity by boosting fiscal spending and trying to delay raising interest rates”, but this would be “unlikely to distract” CEOs and their “pushy” shareholders too much. “If there is any hesitation, the yen, which dropped to a three-month low on 28 October, will at least provide stocks with a short-term boost.”

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The Nikkei 225 is the top stock market index for the Tokyo Stock Exchange. Often referred to as the 'Nikkei Stock Average' or just the 'Nikkei', it consists of the top 225 blue chip companies in Japan listed on the Tokyo Stock Exchange.

Some of the biggest components of the Nikkei include companies within electric machinery, chemicals, services and tech. Most of the companies on the index are major exporters, so the market is not only highly sensitive to the global business cycle but also to the level of the yen. Recent fears of a US recession caused Japan's stock market crash which saw the Nikkei sink by 12% at the start of August.

We look at what the Nikkei 225 is and how you can trade in it.

What companies are on the Nikkei 225?

The Nikkei consists of 225 top companies that trade on the Tokyo Stock Exchange, many of which are global brands. 

It is a price-weighted index. Some of the top companies on the Nikkei include the likes of Sony, Canon, Nissan and Toyota.

The stocks that make the list are reviewed in April and October each year.  The first calculation took place in September 1950. The index represents the history of the Japanese economy following World War II. 

The index consists of around 35 sectors, with tech being the largest, making up almost 50%. Other industries include financials, consumer goods, material, capital goods, transportation and utilities. 

The top 10 companies include:

•  Fast Retailing 
•  Tokyo Electron 
•  Softbank Group Corp 
•  Shin-Etsu Chemical 
•  TDK Corp 
•  KDDI 
•  Recruit Holdings 
•  Fanuc 
•  Daikin Industries 

The price of the Nikkei 225 is affected by share prices of the companies in the index. A wobble in any given sector, like tech, will impact the price of the Nikkei. 

The Nikkei is therefore also sensitive to economic events such as recent interest rate changes, currency rates, earnings reports and even natural disasters which can impact companies listed in the Nikkei.

How can you trade the Nikkei 225? 

Trading in the Nikkei gives you exposure to the Japanese market. You can buy individual shares via your broker or track the index by investing in a tracker fund or an exchange-traded fund (ETF).  

When is the Japanese stock market open? 

The Japanese stock market is open between 9am to 3pm JST - Monday to Friday. The Tokyo Stock Exchange, the main stock market of Japan, is based in Tokyo and is often abbreviated as TOSHO. 

Shigeru Ishiba, Japan’s new prime minister, has announced plans for a snap election on 27 October “in a bid to secure a public mandate” after his surprise victory in the ruling-party leadership contest, says Leo Lewis in the Financial Times. In electing the 67-year-old Ishiba out of a nine-strong field, the Liberal Democratic Party (LDP) has signalled its desire to “mollify an angry public”, says The Economist. His win reflects the “sense of crisis” within the LDP, which has ruled Japan with “only two brief interruptions” since 1955. A run of political scandals and public disaffection over rising living costs caused the party’s approval ratings to plummet, leading Ishiba’s predecessor Fumio Kishida to announce that he would step down in the summer. Although the party is “not yet in danger of losing power, many in the LDP worry about losing a big chunk of seats”. 

Ishiba is a controversial figure within his party, but popular with the public. He has been outspoken throughout his 38 years in parliament and his genuine nature and respect for the electorate has “endeared him to voters” while making him an outsider within his party. Some still regard him as a “traitor” for switching parties for several years in the 1990s, and four previous bids for the leadership failed. So what does he stand for? A “Tokyo native” and one of only two contenders who doesn’t speak English, Ishiba has “both establishment and rebel credentials”, says Charlie Campbell in Time Magazine. He worked briefly as a banker before going into politics after the death of his father, who was also a lawmaker and cabinet member. He is seen as progressive (he supports giving women the right to keep their surnames after marriage and to be empresses) and was the most outspoken detractor of former nationalist leader Shinzo Abe, but he also became known for “flip-flopping” on issues according to the public mood.

What's next for Shigeru Ishiba?

The market reaction to Ishiba’s victory was extreme, but “reflected fragile investor sentiment” regarding a man who has “expressed support for a vaguely defined, more distributive ‘new capitalism’, but has never focused on economic matters”, says Lewis. So far, he has signalled that he will “stick to the policies of his predecessor”, which are still, essentially, “the policies of Abe”, although he has talked about raising corporation tax. He has also promised to revitalise rural areas and address population decline, although how he plans to achieve this is unclear. 

Security is set to be a major focus. Ishiba took office on 1 October and formed a cabinet “made up of numerous security and defence experts in line with his calls to strengthen regional military alliances”, reports France 24. Relations between Tokyo and Beijing are being “tested by China’s territorial ambitions” and Japan also faces a potential threat from nuclear-armed North Korea, says Nicola Smith in The Telegraph. Although Ishiba, a former defence minister, believes in a strong military to counter the Chinese threat – he has said that an emergency in Taiwan would constitute “an emergency in Japan” – he also “chooses his words carefully” and has “called for deeper engagement and more diplomacy with Beijing”. 

Officials in Washington are “nervous” about some of Ishiba’s ideas, most notably his proposal of an “Asian Nato”. He has “long bristled at subordination to the US” and criticised the inequality of the US-Japan alliance. “It is an uneasy thought” to imagine earnest, serious Ishiba discussing his wish to reshape the alliance with a “mercenary, isolationist Donald Trump”, should Trump win the US election, says the Financial Times. However, to succeed as the leader of a divided party, in the short-term at least, he will need to be pragmatic and leave his own “political projects” on hold.

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Shares in Japan’s Seven & i Holdings, which operates 7-Eleven convenience stores worldwide, have risen after it said it was “open to discussions” with Canada’s Alimentation Couche-Tard if the latter improves its $39 billion takeover bid, say P.R. Venkat and Megumi Fujikawa in The Wall Street Journal. Seven & i rejected Couche-Tard’s previous offer last week on the grounds that its proposal “significantly underestimated the company’s value and potential”. This has led to speculation that Couche-Tard will raise its offer, although there may be antitrust concerns over any deal as both firms have large networks in the US. 

Competition will certainly be a “key consideration” in any deal, says Lex in the Financial Times. A merger “would create a global convenience-store leader with more than 100,000 stores”. US regulators will definitely want to become involved. Given 7-Eleven’s operations in the US, both in terms of its own stores and the franchises of other brands that it runs, the combined entity would be America’s “biggest convenience-store operator”. What’s more, because the deal would be the largest foreign takeover of a Japanese firm, Japanese authorities will also be under pressure to scrutinise it. 

Is a takeover likely? 

For a company such as Seven & i to consider selling itself “would have been unthinkable a little over a decade ago”, says The Economist. Japan’s listed firms “have long been known for their hostility to takeovers and their lack of responsiveness to shareholders’ demands”. However, this is “slowly changing” thanks to reforms to corporate governance. Combined with the decline in corporate cross-holdings, which have traditionally been used to fend off hostile takeovers, this means that listed Japanese firms “can no longer simply dismiss takeover attempts out of hand”. 

Opponents of the deal, meanwhile, have a point when they argue that 7-Eleven has “more value than simply its worth to shareholders”, says Bloomberg’s Gearoid Reidy. While not quite a “critical piece of national infrastructure”, 7-Eleven stores provide a “vital local hub in Japanese communities, particularly in rural areas”, with the chain’s “nationwide reach and economy of scale” making its “tasty, nutritious food options available to otherwise isolated elderly people”. Japan’s “often-undervalued brands” should keep such factors in mind when deciding whether to sell up.

In any case, for this deal to present a “real test” of Japan’s receptiveness to foreign acquisitions, Alimentation Couche-Tard “needs to work a lot harder” to come up with a more attractive offer, says Anshuman Daga on Breakingviews. The offer is not only below the level that Seven & i’s share price was trading at as recently as February, but also far short of the ¥3,500 per share break-up value the Japanese chain could command. Any new proposal will also need to include a “large break fee” to compensate for the “extended deal timeline” necessary to allow for a proper regulatory investigation.

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A new month, a new market wobble. Global stocks began September with their worst sell-off since the early August shocker. America’s technology-focused Nasdaq Composite index dropped by 3.3% on 3 September, with artificial intelligence (AI) flagship Nvidia suffering a 9.5% slide. The resulting $279 billion fall in value marks the biggest one-day decline in the market cap of a US stock in history. 

While last month’s plunge began in Japan, this time concern is focused squarely on America. Weak manufacturing data revived fears that the US is on the brink of recession. Nervous markets have become prone to exaggerate “the likely scale of the impending US economic slowdown”, triggering overreactions to small bits of bad data, says Katie Martin in the Financial Times. 

While overvalued “monster” tech stocks flail, the rest of the world’s top economy isn’t looking too bad. Société Générale analysts note that 80% of US stocks beat earnings-per-share expectations in the most recent quarter. Investors should shift their attention from the narrow AI “bubble” to opportunities across the rest of the market, especially in “small- and mid-cap stocks”.

How are AI companies performing? 

The Nvidia sell-off came even though the company delivered another set of “blowout results” last week, says Ipek Ozkardeskaya of Swissquote Bank. The AI-chip specialist topped sales forecasts by $2 billion for the fifth consecutive quarter, served up an unexpectedly robust forecast for the current quarter and announced a big stock buyback. It still wasn’t enough. The shares fell 14% over the next three days. 

Investor “fatigue” with the AI story is evident. Nvidia’s shares have dropped a fifth since a mid-June peak, but have still risen more than 600% since the beginning of last year. “Nvidia is doing fine,” says Dan Gallagher in The Wall Street Journal. The other tech giants lavished $58.5 billion on AI capital spending in the second quarter – great news for Nvidia, which captures a lot of that money by selling its high-end chips to these firms for their AI projects. Projected revenue for the current quarter came in 2% ahead of Wall Street targets, but investors have become used to even bigger beats – in the same quarter last year, revenue outperformed expectations by 28%. 

There are question marks about whether this earnings windfall will be sustainable if consumer demand for AI services fails to appear and tech firms rein in AI spending, but there is little reason to panic yet. Nvidia enjoys huge profit margins of more than 50%, five times the average for the S&P 500 as a whole, says John Authers on Bloomberg. Investors were disappointed by signs that rising margins won’t continue forever. Talk about a reality check. 

The Nvidia share price is unlikely “to burst”, but “speculative froth” is being removed. Peter Atwater of Financial Insyghts notes that prices of the most “speculative” AI trades actually peaked in the spring and have since dropped a fifth. As Atwater puts it, the “peak in the AI frenzy is behind us. Unappreciated by the crowd, it occurred in late February. As they always do, the worst left the party first”.

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Japanese prime minister Fumio Kishida has given up. Beset by public anger about cost-of-living pressures and a party corruption scandal, Kishida has announced that he will not seek re-election as leader of the country’s governing party. He is expected to step down next month. Change at the top of Japanese politics comes as the local stock market recovers from a bruising sell-off, which saw the Nikkei fall 12.4%, its biggest one-day drop since 1987. 

Japanese shares suffered their worst two-day drop since the 1950s, says River Akira Davis in The New York Times. The plunge could mark the end of one of the country’s “most enduring stock rallies” in decades. The benchmark Topix index has gained 36% since the start of last year amid excitement about corporate reform. Yet the speed of the drawdown – which came after the yen strengthened – has left many asking if Japan’s much-vaunted revival was just an illusion driven by currency weakness. The weak yen boosts the earnings of big listed multinationals, such as Toyota. 

The Topix has rallied 15% from its nadir last week, although it is still down 11% since the mid-July peak. Such “absurd” daily swings make Japan resemble an emerging market, says Leo Lewis in the Financial Times. In just a week, the Topix “drunkenly” lurched from being “one of the best-performing major benchmarks of 2024 to one of the worst”. The “whole market is trading like a penny stock”, laments one fund manager. While there have been some “genuine bright spots”, sceptics say that the sell-off has “exposed the true face of an economy” that is still rife with “zombie” businesses, bad management and wasted capital. “Far too many companies” in Tokyo “should not be listed at all.”

Should you buy Japanese equities?

A 20.3% stock plunge over three days marks Japan’s worst performance in data going back to 1973, says Jeff Weniger of WisdomTree. But the crash might spell opportunity. After previous big drops in Japan, the median subsequent 12-month return was 10.9% and the average was 14.6%. The $1.1 trillion drawdown in Tokyo has wiped “some of the froth” off a market that was becoming overheated, say Hideyuki Sano and Aya Wagatsuma on Bloomberg. Valuations look reasonable again, with the Topix on a forecast 13 times earnings, compared with 20 times for America’s S&P 500. The sell-off was triggered by a rate hike from Japan’s central bank, but the bankers – scared by the market’s fragility – now say that they won’t tighten too quickly, cutting the risk of a repeat performance. 

The era of a weak yen propelling banks, insurers, carmakers and tech to the forefront of the Topix is drawing to a close, says James Salter of Zennor Japan Fund. These trades unwound quickly last week after becoming “overcrowded” with foreign cash. “It will take a little time for the market to adjust,” but a stronger yen doesn’t kill the case for Japanese equities. Instead, the baton will now pass to smaller, more domestically oriented stocks that are enjoying the fruits of a “corporate governance revolution”. For investors, the Tokyo crash could ultimately mean “lower prices and better valuations”.

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“The Japanese government no longer knows what to do,” says Yann Rousseau in Les Echos. Tokyo has promised a “firm fight” against yen volatility, but the currency continues its “inexorable slide”, recently hitting its lowest level against the US dollar since 1986. 

This spring the country’s finance ministry spent ¥9,800 billion (£48 billion) on currency-market intervention to prop up the yen. That sparked a brief rally, but the “respite” lasted only “a few days” – then it plunged again. The yen has dropped 12% against the dollar this year, says Mary McDougall in the Financial Times. 

So, what does a weak yen mean for the Japanese economy? In March Japan ended eight years of negative interest rates, but rates are still barely above zero. The central bank has been “cautious” about the prospect of further rises, even as the US central bank, the Federal Reserve, holds rates high. The resulting US-Japan yield gap has powered a re-emergence of the “carry trade”, says Anna Hirtenstein in The Wall Street Journal. 

The trade sees investors borrow in yen at low interest rates and then park the cash in higher-yielding currencies for an easy profit. The carry trade is driving renewed selling in the yen. Data from the Commodity Futures Trading Commission shows that “asset managers have amassed the biggest net short position, or bet against, the yen in at least 18 years”.

Is a weak Yen good for Japanese stocks?

A weak yen is traditionally regarded as a boon for Japanese stocks, says Jacky Wong in the same paper. More than half of the firms on Japan’s Topix index are exporters, and thus benefit from a weak currency. The likes of Toyota and Honda are enjoying “record profits” on the back of the yen’s slide. 

However, there are two drawbacks to a weak yen, say Winnie Hsu and Masaki Kondo on Bloomberg. First, the currency’s “relentless slide” increases import costs. That makes Japanese households poorer, weakening the domestic economy and harming local retail stocks. Second, a weaker yen erodes the returns of foreign investors. The local Topix index has gained 20% this year in yen terms, but only about 7% in sterling terms. 

The yen’s “slump” is starting to prove more harmful than helpful to Japanese shares. Foreign investors have been net sellers of Japanese shares for five weeks in a row. Much blame lies at the door of the Bank of Japan, says Russ Mould of AJ Bell. Under governor Kazuo Ueda the bank has “managed one meagre interest-rate increase”, and it is still printing money as part of a quantitative-easing programme. 

The yen has slumped 62% against gold since the start of last year, vindicating “gold bugs” who have flagged Japan’s bad public finances, “weak demographics” and self-defeating central bankers. We should watch closely – Japan is far from the only developed country to have got itself into this dangerous predicament.

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A professional investor tells us where he’d put his money. This week, Nicholas Price, portfolio manager of the Fidelity Japan Trust, highlights three favourites.

Japan’s delayed reopening and the return of tourists are supporting growth in consumption and demand for services. The economy is also transitioning to a moderately inflationary state as companies are increasing wages and finding it easier to raise prices. There is growing pressure on firms to enhance their corporate value and use excess cash to increase investments and shareholders’ returns. 

We are also seeing the rationalisation of corporate structures and reductions in cross-shareholdings. While signs of weakness in China’s recovery and the risk of a US recession are potential headwinds, this accumulation of positive factors is supportive of the mid-to-long-term outlook for the Japanese market. 

In terms of investment opportunities, Japan’s technology and materials sectors hold promise. Globally competitive companies in semiconductor equipment and electronic components are trading on compelling valuations as we approach the trough of the cycle. There are also niche chemicals firms that command dominant positions in their global markets yet continue to fly under the radar. Another area of the market that I would highlight is the mid-and small-cap growth segment, which is trading at cheap valuations.

Osaka Soda (Tokyo: 4046) is a chemicals company that has transformed its portfolio from highly cyclical, commodity products to more secular growth solutions. Since 2010 the group has expanded its healthcare business and has established a dominant position in chromatographic purification materials, a vital process for the manufacture of GLP-1 and insulin drugs. With GLP-1 drugs, which help manage blood sugar (glucose) levels in patients with Type-2 diabetes, further expanding into obesity treatment, the company is well positioned to meet the rapid growth in demand from global drug makers. Furthermore, the group’s profitability and free cash flow generation have shown a remarkable improvement owing to the high-profit margin of its purification-material business. 

Chemicals group NOF (Tokyo: 4403) commands dominant positions in niche markets, underpinning stable growth in earnings and a high level of profitability. Its core businesses include surfactants (inputs for toiletries and cosmetics) and drug-delivery systems (DDS), which are utilised in mRNA medical technology. While the stock has yet to receive the full recognition it deserves given the strength of its fundamentals, our engagement with management has helped to deliver improvements in disclosure relating to the group’s finances and its environmental and social governance (ESG) policies. We think that enhanced communication with the market and the unwinding of cross-shareholdings will support a re-rating. 

Flourishing funeral service firm Kosaido (Tokyo: 7868) is a funeral service operator in Tokyo. The company owns and runs six crematoriums and funeral halls in prime locations. The cremation business boasts an effective monopoly position and high profit margins owing to limited land supply and barriers to new entrants. Moreover, Japan’s ageing society and the net influx into Tokyo will drive demand for cremation over the long term. Meanwhile, Kosaido is starting to utilise its property to expand the funeral-ceremony rental business, aiming to cross-sell its cremation and funeral services. Given its central location and cost advantages, Kosaido should continue gaining share in the funeral services market.

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Although still the world’s third-largest economy, Japan Inc. has languished over the past three decades. As Nicholas Gordon notes in Fortune magazine, in 1995 there were 149 Japanese firms in the magazine’s Global 500 list of top companies as measured by revenue. That was a close second to America’s 151. Today there are just 41 Japanese companies on the list, compared with 136 from the US and 135 from mainland China. 

In the late 20th century, Japan was renowned for its innovative electronics, cars and video games, but the internet boom has largely passed it by. Norihiro Yamaguchi of Oxford Economics points to a stagnant economy and a “cautious investment culture” as the culprits. 

Yet years of pain may have caused investors to overlook a bargain: the Topix index, a broader gauge of the market than the Nikkei, is “still a fifth cheaper than other developed markets on an earnings basis”. The true discount might be even bigger when you factor in “Japanese accounting’s harsher depreciation charges... particularly versus US companies, who are prone to overstating their profits”. 

This year has brought a renewed bout of enthusiasm for Japanese stocks. Warren Buffett visited the country in April. Berkshire Hathaway, his investment company, has made impressive returns of late from taking positions in local trading companies (known as “sogo shosha”), one way to gain broad market exposure. 

For markets, Buffett’s visit was interpreted as a blessing imparted upon Japanese equities, bestowed by one of the investment greats. The Topix has soared by one quarter this year, making it one of the world’s best-performing markets, while the Nikkei has topped 33,000 points for the first time since 1990. 

Reform story has room to run

A key plank of the Japanese bull case is that corporate reforms initiated by Shinzo Abe post-2012 have laid the groundwork for “a sustained improvement” in the profitability of Japanese firms, say Marcel Thieliant and Thomas Mathews of Capital Economics. But the record is mixed. 

Valuations suggest that the corporate reform story still has room to run. This year the Tokyo Stock Exchange (TSE) has started pushing firms with a price-to-book (p/b) ratio of less than one, to up their game, say Masaki Taketsume and Taku Arai of Schroders. Management at firms with consistently low valuations will be required to present plans to remedy the problem. 

A p/b of less than one means that the market is valuing the company at less than its assets are worth, which suggests that a company’s capital is not being well used. As of the end of May, slightly over half of TSE stocks traded at this deeply discounted level. There is thus plenty of low-hanging fruit for Japanese managers to pick to give share prices a lift.

On other metrics, Japan also looks cheap even after this year’s rally. As of 31 May 2023, Japanese stocks were on a cyclically adjusted price-to-earnings (Cape) ratio of 14, a 15% discount to the 15-year median and the same level as the historically cheap British stock market. 

Nobody is betting on a repeat of Japan’s 1980s mania. Decades of stagnation have made permabulls all but extinct in the land of the rising sun. Yet its sun doesn’t need to rise right overhead to warm up your portfolio. 

All investors in Japan need is for corporate reform to keep delivering steady improvements in shareholder value while it charts a path back to normal monetary policy. Japan offers reasonable valuations, a pro-market government and a degree of political stability that is the envy of most of the democratic world. Long out of favour and lost in translation, Tokyo’s capacious equity market contains plenty of hidden bargains. 

Invest in Japan: What to buy

Japanese stocks make up 6% of the MSCI World index of developed markets. “All investors should have some exposure... [5%-10% of your portfolio] would be broadly sensible,” Rob Morgan of Charles Stanley tells Leonora Walters in the Investors’ Chronicle. 

Of the large-cap tracker funds, the Fidelity Index Japan Fund has the lowest ongoing charge at 0.1%. Other trackers include the iShares MSCI Japan (LSE: IJPN) and the Vanguard FTSE Japan (LSE: VJPN), which have ongoing charges of 0.59% and 0.15% respectively. The latter two have returned 11% over the last five years and 70% over the last ten years in cumulative capital gains, providing a useful benchmark against which to test active managers. There is a robust case for active funds in Japan: the market contains hundreds of under-researched small companies, raising the odds that a savvy manager can net a few bargains. 

The Baillie Gifford Japan Trust (LSE: BGFD), which focuses on medium and smaller-sized firms, has slipped by 3% this year. On a ten-year view, the 125% gain is creditable, however, especially when you consider the 1.21% dividend on top. The trust has a 0.66% ongoing charge and trades on a 6% discount to net asset value (NAV). It should offer broad exposure as Japan’s economy continues to revive.

Similarly, the JPMorgan Japanese Investment Trust (LSE: JFJ) also pays a dividend and has outperformed the Baillie Gifford Trust over the past five years. It has a competitive 0.7% ongoing charge and trades on an 8% discount to NAV. The Fidelity Japan Trust (LSE: FJV) doesn’t pay a dividend and has gained 148% over the last decade. There is a 0.94% ongoing charge and the 12% discount to NAV means that investors are getting a sizeable extra discount on top of Japanese assets that are already cheap. 

The Schroder Japan Trust (LSE: SJG) has gained 12% so far this year. It also pays a 2.1% dividend yield. But the trust went nowhere in the five years before 2023. Wary investors have thus slapped a 10% discount to NAV onto the trust. It has a 0.92% ongoing charge. 

Finally, the AVI Japan Opportunity Trust (LSE: AJOT) takes an activist approach to unlocking value in corporate Japan. It buys into overcapitalised small and mid-cap firms that look undervalued and then engages with management to encourage it to take steps to unlock shareholder value. The ongoing charge of 1.61% is high, but is arguably justified by the extra work required. The trust only launched in October 2018, but early signs are encouraging, with a 15.8% gain since launch. The concept seems to have captured the imagination of investors, so it trades on only a slight discount to NAV and yields 1.32%. It is one to watch.  

We’ve been telling you to buy Japanese stocks for the best part of two decades, although for the most part, this trade hasn’t worked out.

However, this year, Japanese equities are soaring. The Nikkei 225 Index has jumped an impressive 19.8% on a total return basis since the start of the year, taking the index to a 33-year high. In comparison, the MSCI AC World Index has returned 8.5%.

The weak yen is one factor behind the growth. As the Bank of Japan has continued to pursue a loose monetary policy in the face of global inflation, the yen has sold off against other currencies, improving the global price competitiveness of Japanese exports.

Japan is a major exporter of both vehicles and parts, electronics, and heavy machinery. A weak yen is also boosting Japanese companies’ overseas earnings when these are bought back into the country.

But there are other, more important factors at play here. These suggest there’s far more to the equity rally than just a cheap currency.

The bear case for Japanese stocks

Whenever Japanese equities have been recommended in the past, (and not just by us) bulls have always touted low valuations as a reason to buy.

Buying stocks when they are cheap or value investing has historically been a good way to grow your money. But this strategy does have its downsides. Cheap stocks can remain cheap forever unless there’s a catalyst. I’m not interested in buying a cheap company unless I know I can make money from it. If it’s going to remain cheap, I won’t make any money, so I won’t buy the stock.

And that’s the problem Japanese equities have had for around two decades. They’ve looked incredibly cheap, but there’s been no catalyst.

This seems to be changing. I’m aware I’m dangerously close to making another overly bullish prediction about Japanese equities. Still, I do see glimmers of a catalyst that could continue to drive equities higher.

Japanese equities have struggled over the past couple of decades because the economy has struggled. Inflation and economic growth have remained tepid. Even though the country exports a huge volume of goods and services, this has not translated into growth in the domestic economy.

If the economy is struggling, companies will struggle to grow earnings and investors will be reluctant to pay more for the same earnings stream as last year. Japanese businesses have also been averse to such shareholder value creation strategies, such as aggressive share repurchases, and large dividends.

In reality, tinkering with shareholder returns is only part of the equation. Without economic growth, the country’s equity market was always going to struggle.

The good news is wages are starting to pick up - great news for the economy.

The changing face of Japan’s labour market

Japan's labour unions have won overall pay gains of 3.67% in this spring's negotiations, a 30-year high for the country according to the Japanese Trade Union Confederation, the nation's largest labour organization.

By some estimates, this wage growth will boost consumer spending by 0.6% in nominal terms, and gross domestic product by 0.4%.

However, the headline figure of 3.67% masks more meaningful changes. The Nikkei Asia reports Japan's top retailer, Aeon, has hiked wages for its 400,000 employees by 7%. Meanwhile, those workers changing jobs have been able to pick up double-digit pay increases.

Higher wages are translating into inflation and GDP figures, and it looks as if this trend will continue.

Carl Vine, co-head of M&G’s Asia Pacific equity team has seen a noble increase in companies increasing prices for the first time in decades. Some manufacturers have not increased prices for 20 years, meaning their staff haven’t had a pay rise in this period either. Now staff are asking for pay rises and businesses are having to figure out what to do.

When I say they’re having to “figure out what to do” they really are. Vine has seen companies panic because they’ve never raised their prices. The “pricing mechanism at the company level is non-existent,” he says. It’s difficult to understand for most of us in the UK what this means. Some Japanese companies just don’t know how to raise prices and many workers haven’t had pay rises in decades.

They’re now making these changes. Attitudes are changing, “companies are saying I’m going to raise prices as I need to defend my margins,” notes Vine, suggesting a “radical overhaul in the way Japan is thinking about prices.”

Businesses are putting plans in place to change prices, and once these are in place, it’ll be easier to raise prices in future.

The bull case for Japanese stocks

There’s also huge scope for the country to improve productivity. Japan’s productivity per worker is amongst the lowest in the developed world. If it were the same as the US, GDP would be 40% explains Vine.

Here’s another growth string the country can pull. Higher wages may force companies to invest more in automation, enhancing productivity and GDP growth.

So, there are some very tangible signs it is different this time. Japan’s labour market seems to be waking up after decades of slumber, which is likely to drive GDP growth and higher corporate profits.

Of course, there’s always the risk this could be another false dawn for Japanese equities. So, investors might not want to commit too much of their portfolio just yet. But, considering the bleak outlook for the rest of the global economy this year, Japan is certainly looking to be one of the main growth stories of 2023.

MoneyWeek’s pick for exposure to the region is AVI Global Trust (LSE: AGT). It has a value remit and has a geographically diversified portfolio with 26% of assets invested in Japan, 35% in Europe (ex UK) and over 20% in North America implying this trust has some protection if Japan’s recovery turns out to be another false dawn.

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When, in 2011, I last came to Japan, the Nikkei 225 index was at the bottom of a long bear market, having fallen by 75% in 22 years. Periodic rallies had not been sustained as, it was commonly agreed, most Japanese companies were not run for profit. Protected from shareholders and predators by cross-holdings, boards focused on themselves and staff loyalty.

Government bonds yielded just 1.25%, the lowest in the world, which seemed absurdly overvalued given Japan’s high government debt relative to the size of the economy. Many had sold bonds short in the expectation of higher yields but this trade became known as “the widowmaker” as it had persistently failed.

The yen was trading at 120 to the pound, making Japan seem expensive, and the economy had stagnated for 20 years. Japan had to change, everyone thought, and become more like the West rather than languishing in outdated social, political and economic structures.

It didn’t take long to realise how wrong this view was. The Japanese economy expanded slowly because the population was falling, so growth in GDP per capita was competitive with other Organisation for Economic Co-operation and Development (OECD) countries. Low

population growth was partly the result of negligible immigration but Japan’s reluctance to open its doors will have attracted the envy of countries, such as the UK, suffering housing shortages.

An almost total absence of crime meant low expenditure on law enforcement and security while the number of lawyers, just one tenth in relation to population compared with the UK, suggests a lot less waste of resources in litigation, regulation and compliance. Japan, it seemed, had never closed a railway line, which resulted in superb public transport. Needless to say, the railways are privately run.

The service sector was regarded in the West as absurdly overstaffed, disguising unemployment, but what that meant was outstanding service. Japan’s vast cities were possible because neighbourhoods were self-contained, with residents not needing to drive out to hypermarkets and retail parks. Far from Japan moving to the Western layout, the reverse is taking place.

A culture of zero inflation

Most important of all was the culture of zero inflation. Prices for the same goods were the same almost everywhere and didn’t change. It didn’t occur to businesses to raise prices. If they had, customers would have walked away.

I came back to the UK thinking that Japanese bonds, far from being overpriced, were good value given zero inflation, and so it proved; the Japanese economy was no basket case and, as its companies evolved, equities would perform strongly over the long term.

Twelve years on, the numbers have changed. The Nikkei 225 index stands at 27,500, up from 10,000 12 years ago and yields 2%. The yen has fallen to 167

to sterling, limiting the equity gains for UK investors, but now looks far too cheap. Japan is now an inexpensive country to visit, while living according to Western habits and tastes has gone from expensive to reasonable, and living as the Japanese do has gone from reasonable to cheap.

Annual inflation is no longer zero but, on the latest numbers, just 3.3%. This is the result of higher energy costs but the reopening of Japan’s nuclear reactors, closed in 2011, will reduce its dependence on imported energy. Ten out of 33 have reopened and another 16 are

awaiting approval. The culture of zero inflation hasn’t changed. With little immigration, property prices are low and renting is eminently affordable.

The number of tourists is now a multiple of the number 12 years ago and the country is much more international, and thus easier to navigate. This must have fostered significant growth in the small businesses that service this change and technology has affected the

economy as much as anywhere else – notably in cashless payments. Growth is therefore very visible.

Petrol costs just £1 a litre and there are very few electric vehicles. On the other hand, there are few big fat cars and a vast number of compacts, most of them hybrids. Overall, Japan has probably been more successful at reducing hydrocarbon consumption in road vehicles than the UK.

Everything works. Public transport is always bang on time, there are public conveniences everywhere (even at the top of a mountain I climbed), vending machines for drinks are ubiquitous and assistance for travellers is always at hand. Courtesy is deeply ingrained in the Japanese culture.

Perhaps most importantly, Japan appears at peace with itself. Change happens slowly but the direction of travel is one way. This must be a godsend for businesses and citizens, making planning for the future simple. It is a crowded but immaculate and beautiful country.

For those keener to invest than to visit, the prospect is equally attractive. With the yen so cheap, currency appreciation is likely to add to returns, rather than lower them, as it has for the last 12 years. The stockmarket trades on about 12 times prospective earnings,

more expensive than the structurally and politically challenged UK market but considerably cheaper than the US. Moreover, companies are much more focused on profits. Thirty-year government bonds yield 1.35% but ten-year yields, negative three years ago, are still under 0.5%. Don’t be so sure that this is unattractive compared with 3.5% on ten-year US Treasuries or 3.8% on UK gilts; the big return should come from long-term currency appreciation.

Investment in Japan will never again be as exciting as it was in the 1980s, when for a time it constituted around half of global indices. But for steady long-term returns it is probably the most attractive of all developed markets across all asset classes.

It’s been a disappointing two years for investors in Japan despite valuations being demonstrably cheap. The Topix index rose just 1.9% in sterling terms in 2021 and has fallen 7.3% in the year to date. Returns in yen were better, but the yen fell 10.8% last year and a further 5.3% in the year to date.

Yet inflation in Japan is below 3% and ten-year bond yields are just 0.25%. The last 18 months don’t follow a period of stellar returns – over the previous three years, the Topix returned only 14% in sterling. No wonder the bulls of Japan have gone quiet and global investors have lost interest: the average allocation of global investment trusts is around 4%.

The better-known specialist trusts managed by Baillie Gifford, Fidelity and JPMorgan are growth-orientated, so they have severely under-performed over both one year and three years.

The top performing Japanese value fund

The best performer last year was AVI Japan Opportunity (LSE: AJOT), a value fund that returned 14% but is down 4% this year. With £170m of assets, it trades at net asset value (NAV). AJOT invests alongside its sister trust AVI Global, a £1bn trust with around a quarter of its assets in Japan.

It holds “a focused portfolio of overcapitalised small-cap companies with a view to engaging with company management and helping them to unlock value”. The key here is that although AVI is an activist investor, it is not a hostile one, realising that a confrontational strategy does not work in Japan.

“AVI can point to a number of engagement successes that have led to share-price out-performance,” say analysts at Kepler Research. They attribute this to AVI investing in high-quality, under-researched businesses at very attractive valuations: the market value plus debt of the average investment is 5.6 times operating profits, just a third of the benchmark index.

The portfolio is highly concentrated, holding 25 stocks with an average market value of £500m. These companies may be listed subsidiaries of larger firms, have surplus assets that could be disposed of without affecting core operations, or just out of favour with investors.

A specialist in small-cap Japanese value stocks

Morant Wright also mostly invests in small-cap Japanese value stocks, but does not take an activist approach. It is a small specialist manager with £1.5bn under management in five open-ended funds, two of which are aimed at UK investors. The LF Morant Wright Japan Fund has 52 holdings, trading on an average price/book value of 0.69 and an average price/earnings ratio of 9.6.

Around 73% of its net assets are in listed investments or cash and 39% of the portfolio is in firms with a market value above £4bn. The higher cost A shares (annual management charge of 1.5%) have returned 311% since inception in May 2003, 22% ahead of the Topix index in sterling. It was 4% ahead last year and 7% ahead in the year to date, but 16% behind in 2020 and also behind in the two previous years.

Outperformance from pure stock pickers

The LF Morant Wright Nippon Yield Fund has similar characteristics, but is less backed by cash and investments (54% for the average holding). It yields over 4.5% and its A shares have outperformed the Topix in sterling by 225% since inception in 2008, with a 18% return in the last 12 months.

Morant Wright invests in firms with “strong balance sheets, attractive business franchises and low valuations”. Like AVI, the managers are pure stock pickers but “low valuations for our firms have combined with a depressed currency to create a compelling investment opportunity”.

Similarly, AJOT says it “has been able to buy into a number of new firms whose previously high valuations had held them back from investing” and also notes “it has become increasingly easier to successfully engage with firms”.

The growth funds are probably ripe for recovery, but investors should find room in their portfolios for long-term value-orientated funds as well.

Japan “has a chance to break free from decades of low or no inflation”, says The Economist. The aftermath of the Covid-19 pandemic and the global surge in commodity prices “seem to have done what years of loose monetary policy could not”. Annual inflation hit 2.6% in July, with the Bank of Japan (BoJ) expecting inflation of 2.3% for the current fiscal year. Excluding sales tax rises, that “would be the first time prices outstrip the bank’s 2% target since it was introduced in 2013”.

Rising prices have generated some disquiet domestically, but Japan’s inflation is “quite mild” compared with levels in many other developed countries, says Aaron Beck in The Wall Street Journal. The BoJ looks unlikely to “flinch” from its current ultra-loose monetary policies.

Japanese inflation is largely driven by higher import prices – economist Richard Katz notes that “88% of Japan’s inflation over the past three months came from volatile food and energy prices” – so the Bank feels little need to cool the economy. Local wage growth also remains sluggish.

The growing gap between tighter monetary policy globally and loose money in Japan pushed the yen to a 24-year low against the dollar this month. Interest rate differentials prompt traders to sell the yen in favour of assets denominated in currencies that offer higher returns. The yen started the year at ¥115 to the dollar but has since slumped to ¥144.

Is the yen no longer a safe haven for investors?

Analysts warn that the market may “soon test the late 1990s low of ¥147 against the dollar”, says the Financial Times. The yen has historically been considered a safe haven in troubled times, but it has plunged despite this year’s geopolitical chaos. A cheaper yen would also be expected to encourage overseas investors to buy up Japanese stocks, but “foreigners have been net sellers of more than ¥650bn of stocks since January.”

Maybe they should take another look. Mass outsourcing means a weaker currency doesn’t provide a boost to Japan’s manufacturing economy like it used to, says Yann Rousseau in Les Echos. But large firms still benefit because overseas earnings are inflated when translated back into yen terms. Indeed “Japan’s corporate profits have risen to their highest levels since 1954”, says Yoshiaki Nohara on Bloomberg. That has helped the Topix stockmarket benchmark, down just 2% this year, to outperform many others.

Corporate Japan’s “newfound earnings resilience” also rests on improving capital discipline after years of reform, Daniel Blake of Morgan Stanley told Aya Wagatsuma on Bloomberg. With local monetary policy set to remain loose, Japanese stocks look “better able to withstand the pressures facing peers around the world”. Just watch out for the plunging currency.

The deal may still fall apart at the last minute. The government may step in to block it. Shareholders may get cold feet. But the takeover of the Japanese conglomerate Toshiba by the buyout giant Bain Capital looks close to completion.

If it happens, it will be among the largest buyouts of a listed company ever staged. It could also pave the way for a series of buyouts of Japan’s ageing, uncompetitive conglomerates, opening up a huge range of opportunities for their global competitors and for investors as well. Toshiba has a long and distinguished history stretching back to the 1870s, but it has been in trouble for years.

It has been beset by a series of accounting scandals, management upheavals and troubled takeovers, while competition in many of its main markets has been getting fiercer, which forced it to slim down and retrench. If you wanted to write a textbook on ineptly managed conglomerates, you couldn’t ask for a more perfect case study. Bain’s offer will probably come as a relief to shareholders and indeed to management, even in Japan, where takeovers, and foreign ones especially, have always been disapproved of.

The first of a wave of deals

In itself it will be a huge deal. When, and if, a final price is agreed, Toshiba is likely to cost Bain at least $20bn, putting it in the top 20 buy-out deals of all time. So long as it has a free hand, Bain should be able to make plenty of money on that investment. Toshiba, like many Japanese companies, has a sprawling range of units, ranging from air conditioners to consumer electronics to medical equipment, office systems, and IT management. There are probably dozens of little businesses within it that just need capitalising, some fresh ideas, a burst of energy, and can suddenly be brought back to health and sold off at a big profit.

It will certainly be a lot easier to make money from Toshiba than from a business such as Morrisons, sold to private equity for a fat price last year, which is already very efficiently run and operating in a very competitive market.

The deal may well open the door to a wave of private-equity deals in Japan. If so, that will be a unique opportunity and one of the most compelling of the 2020s. Japan has lots of great businesses that are ripe for a shake-up. Sony would be a very tempting target for one of the tech giants. Toyota is one of the best carmakers in the world and its two domestic rivals, Mazda and Honda, have fantastic niches and strong reputations. Takeda has formidable drugs research ,distribution, and manufacturing in its domestic market, and would surely be a tempting acquisition for Pfizer, GlaxoSmithKline and AstraZeneca, especially if it was broken up into separate units.

Japan also has lots of vast, sprawling conglomerates of the sort that were all broken up in the US and UK 30 years ago. There are companies we have hardly heard of, such as Itochu, with a value of more than $50bn, which has six divisions from food to textiles, all of which could be knocked briskly into far better shape and then listed as separate companies, or sold off to their global rivals.

Rich pickings for investors

There are three broader opportunities that the Toshiba deal can unlock. For the giant buyout firms, Japan could open up a whole new wave of potential targets, and at precisely the time when traditional hunting grounds such as the UK and US were starting to look difficult. It will take a lot of capital – not many Japanese conglomerates will cost less than the $20bn Toshiba is likely to command – but the returns will be handsome. Second, there will be opportunities for some of the world’s biggest companies to pick up choice businesses in food, consumer goods, engineering and electronics as units get spun out of the conglomerates that controlled them. This could boost earnings and market share. And finally, there will be plenty for shareholders. If the private-equity firms rip through Japan, the market will finally start to deliver after three decades of dismal returns, and the buyout funds will be a pretty good bet as well.

This week the Tokyo Stock Exchange launched its biggest shake up since 1961 in a bid to attract foreign investors. The exchange has scrapped a “cumbersome system of four separate boards” for a more streamlined split into three new sections – “prime, standard and growth”, say Eri Sugiura and Leo Lewis in the Financial Times.

A key part of the plan is to make prime a more exclusive category than the unwieldy “first section” it replaces. That includes tougher requirements on market capitalisation and corporate governance (an area in which Japan has long lagged).

One-third of board seats are supposed to be held by outside directors. Such rules are meant to prod firms towards reform. But numerous loopholes have disappointed critics, with companies let into prime even if they fail to qualify so long as they show how they plan to do so “at some unspecified point in the future”. The reform looks to be a “squandered opportunity”.

Cheap yen, cheap stocks

But other developments could draw foreign investors to Japan. Core consumer inflation is still running at just 0.6% per year, so the Bank of Japan is sticking to its policy of ultra-loose money, unlike other central banks. That includes unlimited purchases of government bonds to keep borrowing costs low, meaning that overseas currencies offer higher rates. That’s prompting bond investors to sell the yen, which has slumped to a seven-year low against the dollar.

Loose policies and a weak yen should be a tailwind for stocks. “Taking comparative rates of inflation into account, the yen has halved in value against the dollar since 1995, taking it back to levels not seen since the early 1970s,” says Peter Tasker in Nikkei Asia.

That makes Japanese products and services look “extraordinarily cheap”. That will incentivise the onshoring of supply chains – a theme in vogue at the moment – as well as “the mother of all tourist booms” once global travel picks up. The “bargains” on offer in the “great Japanese discount store… will not be there forever”.

That said, long-term investors still need to see economic reforms, not a cheap currency. Tokyo has been “courting a weak yen” for at least two decades, says William Pesek, also in Nikkei Asia. That has delivered “record profits” for export-oriented businesses, but it has also depressed wages, acted as a drag on innovation and investment, and reduced “the urgency to restructure the economy”.

In 2013, then-prime minister Shinzo Abe promised bold changes to end Japan’s stagnation. But of the “three arrows” in his programme – easier money, fiscal reform and less red tape – only the monetary one “was fully deployed” and now even “that one is falling to earth” along with the yen. “If the secret of success was a weak currency, then Argentina and Venezuela would be booming.”

Japan is open for business again. The country’s borders have been sealed for long periods during the pandemic, but last week Tokyo announced that foreign students and business travellers will be allowed in from next month, say Wataru Suzuki and Francesca Regalado for Nikkei Asia. Quarantine rules will also be eased, although tourists remain barred for now. The announcement follows public pressure from business groups and universities. The border measures have deterred foreign investment and encouraged talent to head elsewhere.

Meanwhile, the benchmark Topix stock index has recovered from its Covid-19 slump and trades 8% above pre-pandemic levels. However, it has followed other world markets lower this year and entered a technical correction (defined as a 10% fall from a recent peak) last month.

Ready for prime time

Back in the 1980s the Tokyo market was a behemoth, accounting “for some 40% of the world’s stockmarket value”, says Suryatapa Bhattacharya in The Wall Street Journal. Yet things went south at the end of that decade and today it ranks behind bourses in New York, Europe and China in terms of market capitalisation. About half of stocks listed in Tokyo trade for “less than their book value”, a sign that investors have little faith in the ability of managers to create value. Japanese blue-chips have long been accused of “sitting on cash and stagnating”.

The Tokyo Stock Exchange is trying to shake up that image with “the biggest overhaul in 60 years”. It wants to create a new elite section called “Prime”, with stricter rules for members about independent directors and communications with investors. However, loopholes in the new rules mean critics think the changes amount to little more than “window dressing”.

Small is beautiful

Still, corporate reforms over the past decade have started to make a difference, says Max Godwin of Eastspring Investments. “Deleveraging of balance sheets, rising dividend payouts, stock buybacks” and more “contested takeovers” are all positives for investors. Perhaps most intriguing are smaller stocks, which are less heavily covered by analysts and make up about two-thirds of the investment universe. With “undemanding valuations”, the “small- and mid-cap space is prime territory for longer term valuation-driven stock pickers”.

Business confidence is strong, as evidenced by “share buyback activity at a ten-year high” and strong “capital expenditure levels”, adds Mary McDougall in the Investors’ Chronicle. Valuations are attractive, with the MSCI Japan trading on a 12-month forward price-to-earnings ratio of 15, compared to the developed-market average of 19.5. Investors in Japan have learnt from bitter experience not to get too excited, but “there are reasons to be cautiously optimistic for 2022”.

Japanese voters “opted for stability” during a general election on Sunday, says The Economist. The ruling Liberal Democratic Party (LDP) lost seats but retained its majority. It now falls to prime minister Fumio Kishida to put bones on his “fuzzy” pledges to create a “new model of capitalism”.

The Topix stock index rallied by 1.8% on the morning following the vote. Investors were relieved that the election delivered a stable government, rather than the more fractured parliament polls predicted.

Turnout was low as voters were presented with “few meaningful” policy differences, says Naoya Yoshino in Nikkei Asia. “Economically, both sides put forward generous distributive policies [centred] on direct financial benefits to the public.” There was little “real debate” about how to pay for it, nor about how Japan plans to decarbonise its economy. Investors are confused by Kishida, say Gearoid Reidy and Min Jeong Lee on Bloomberg. Some deride him as a dull continuity candidate who will continue the pro-market policy direction initiated by Shinzo Abe in 2012. But others wonder whether his talk about creating a “new capitalism” marks a more decisive break with Abe.

Japanese stocks slumped in the weeks following Kishida’s elevation to the premiership in October, says Mariko Oi for the BBC. His idea that capital-gains tax should rise drew an angry reaction from business, prompting an “embarrassing policy U-turn”. While markets assess Kishida’s inclinations, the stocks continue to appeal.

More shareholder-friendly corporate governance, excellent multinational companies, high vaccination rates and advancing digitalisation mean that investors would now do well to follow the lead of so many Japanese voters and tune out the country’s politics.

Investors appear unimpressed with Japan’s new leader. The ruling party has chosen Fumio Kishida to replace Yoshihide Suga as the head of the world’s third-biggest economy. Kishida was the continuity candidate.

That means more loose fiscal and monetary policy, “decarbonisation, digitalisation” and the “promotion of free trade”, says Ma Tieying of DBS. The new government is preparing to launch yet another stimulus package, worth at least 5.5% of GDP. Happily, Covid-19 is back under control in Japan, with vaccination rates now exceeding those in the US. Japanese stocks rallied in September when Suga announced his resignation, say Toshiro Hasegawa and Gearoid Reidy on Bloomberg. There was hope that Japan could turn the page on a difficult year. It is a measure of just how “uninspiring” investors find Kishida that the benchmark Topix index has since given back all of their post-Suga gains.

Kishida has got off to a bad start with investors, say Leo Lewis and Kana Inagaki in the Financial Times. This week he suggested that he could increase Japan’s capital-gains tax. The resulting selloff, dubbed the “Kishida shock”, sent the Topix down by 3% on Tuesday. Higher taxes would mark a “sharp reversal” from the pro-investment line taken by Tokyo since 2013.

Japanese investors aren’t that gloomy, say Hideyuki Sano and Tom Westbrook on Reuters. The country’s shares outperformed both the US and Europe last month. A better Covid-19 picture and improved corporate earnings outlook also bode well. Supporters view Kishida as “a steady consensus-builder”, but many doubt he can see through overdue structural changes to Japan’s “old-fashioned” bureaucracy. He will face the voters in a general election at the end of this month.

Japanese stocks have hit a 30-year high following the resignation of prime minister Yoshihide Suga. Suga, who has only been in office for a year, had become widely unpopular as his government failed to get on top of a surge in Covid-19 infections.

A slow vaccine rollout and the controversial decision to go ahead with hosting the Olympics despite the pandemic also sapped his support. He will step down before a general election scheduled for later this year.

Japan’s Topix index reacted to the news by hitting its highest level since April 1991, says Bloomberg. Investors had once had high hopes for Suga, who vowed to accelerate Japan’s digital shift (see also page 28). In February this year the Nikkei 225 index hit the symbolic 30,000-level for the first time since 1990. Yet it fell back as Covid-19 came to dominate his premiership: “Suga had created an atmosphere of uncertainty… there was a perception that Japan was ‘in a mess’”, says Richard Kaye of Comgest Asset Management Japan. The Topix has gained 6.5% during the past month alone.

In most countries investors dislike the uncertainty of an upcoming election, says Takeshi Kawasaki for Nikkei Asia. Not in Japan. “Looking at the ten early elections held since 1990, stocks rose nearly every time between the day of the lower house being dissolved and the election date”.

What seems to happen is that headlines about Japanese politics grab the attention of foreign money managers. They decide they like what they see and buy. “Typically at the mercy of trends in US equities” thanks to Wall Street’s tendency to set the tone for world markets, Japanese stocks are likely to go their own way over the coming months.

Last Friday, Japanese prime minister Yoshide Suga resigned, saying he would not seek re-election after spending just one year in office.

His term, which is due to finish at the end of this month, was marred by rising Covid-19 infections and a spate of poor policy decisions.

While it is unclear who will succeed him, the Japanese stockmarket has welcomed his departure, hitting a 30-year high. The country’s wider TOPIX Index hit its highest level since April 1991, while the Nikkei jumped to its highest level since April this year.

There are a number of possible successors with Fumio Kishida, the former foreign minister; Sanae Takaichi, the former minister of internal affairs and telecommunications; and vaccine minister Taro Kono all popular choices.

But the outspoken Kono appears to be the front-runner and is leading in many polls, according to media reports.

So does this usher in a new era of growth in Japan’s stockmarket?

For Shoji Hirakawa, chief global strategist at Tokai Tokyo Research, Suga’s departure has reduced the chances of the ruling Liberal Democratic Party losing in the next election:

“With Suga not running in the LDP leadership election, there’s less chance of the LDP losing badly in the upcoming general election -- that will give support to the stockmarket.”

As Daniel Madden, chief market analyst at Equiti Capital, tells MoneyWeek, the market rising despite the successor not being known reflects investors’ relief. “The prospect of a new prime minister is enticing to investors as they well remember the surge in equities [in] the run up to the election of Mr Abe in 2012,” says Madden.

In 2012, Japanese stocks rose almost 23% after Japan’s then incoming government vowed to reinvigorate the long-suffering economy. Japanese equities had been in recovery mode after hitting a low in 2012 caused by the devastating earthquake and tsunami that hit in 2011.

But despite recent strength, Japan’s stockmarket has been unloved and misunderstood over the last several years.

So why have Japanese stocks underperformed relative to other markets?

Japan has been beset with decades of deflationary pressures, and despite efforts to prop up prices, deflation has remained stubbornly high.

When inflation is high, it means asset prices are rising and it encourages investment in the stocks. The opposite applies in a period of deflation where asset prices are falling, meaning cash and other liquid assets look more attractive.

Japanese markets have suffered the longest downward trajectory in any major stock market in living memory. In December 1989, the Nikkei index reached a record high of almost 39,000, but only regained the 30,000 mark earlier this year.

Adding to that was a downward trend in treasury yields. For the last 20 years, Japan’s market was largely a trader’s market. Investors could follow an active approach and make money by buying specific company stocks that looked more promising than others, while neglecting the overall market. Investors who chose to trade the entire market had to make sure they got their timing right, which meant it was hard to make returns.

But over the past decade, Japanese equities have fared better than the previous two decades. What changed?

The answer simply points to one man: Shinzo Abe.

Shinzo Abe’s sweeping changes

In 2014, the then prime minister, Shinzo Abe, initiated a push to modernise the country’s corporate governance. He encouraged businesses to appoint more outside directors to boards and made delivering value to shareholders a core focus.

Wouldn’t that be expected anyway from a major economy? As AVI Japan Opportunity Trust’s Joe Bauernfreund told the MoneyWeek Podcast, Japan’s market has historically been different, as post-war attitudes were much more collective and stakeholder focused than shareholder focused; Japan was much more interested in keeping as many people employed as possible, rather than focusing on specific shareholder needs.

But since the Corporate Governance Code and Stewardship code were introduced, there has been an uptick in corporate activity.

What is the outlook?

So with that in mind, should you buy Japanese stocks?

Japanese stocks are rising as investors are only now realising how cheap they are, says Shoichi Arisawa, general manager at investment banking and brokerage firm, IwaiCosmo Securities.

Suga’s exit has also triggered a rise in the country’s telecommunication companies. Shares in Japanese telcos, Nippon Telegraph & Telephone Corp and KDDI Corp have shot up since Suga’s resignation on hopes that the country’s new successor will have more favourable policies towards the country’s mobile-phone industries. Reducing the cost of mobile plans was a major focus for Suga during his short-lived premiership and even before that while he held the position of chief cabinet secretary in 2012.

Another reason to buy is the Nikkei’s low price/earnings (p/e) ratio of 13, which is “cheap” according to Arisawa. The US market is on a rating of around 22, so it’s definitely worth keeping Japanese stocks (and particularly the nation’s telcos) on your radar.

For Japanese growth stocks, look at the Baillie Gifford Japan Trust (LSE: BGFD), while those interested in value should consider the AVI Japan Opportunity Trust (LSE: AJOT).

“Welcome to the weirdest of Olympics”, says Scott Stinson in Canada’s National Post. A flare-up in Covid-19 cases prompted the city to bring in strict restrictions, so the games opened in an expensive, gleaming but almost empty stadium – “not exactly what Tokyo first had in mind”.

“I feel sorry for the organisers,” says Liam Halligan in The Daily Telegraph. “They are trying to stage the biggest sporting event on earth… under astonishingly difficult circumstances.” A bar on spectators means the hoped-for boost to the local leisure industry won’t materialise. “The contrast with the 1964 Tokyo Olympics”, which came to symbolise Japan’s “astonishing post-war economic renaissance… is heart-breaking.”

Decades of disappointment

The post-war boom ended in the early 1990s. The Nikkei-225 index peaked close to 39,000 in 1989 and has never returned to that level. This week, at around 28,000, it was still 28% short of the 1989 peak. The Topix index, a more accurate measure of the market than the Nikkei, finally regained its 1991 levels in February 2021.

Japan’s markets have suffered “the longest downward phase in any major stockmarket in living memory”, says Ian Cowie in The Sunday Times. “Even very patient investors cannot be sure of topping the podium”. Still, this is the world’s third-biggest economy and “the first step towards making a profit is often to buy low”. On a price/earnings (p/e) ratio of 17, Japan is much cheaper than America’s rating of 22.

Japanese shares have underperformed this year, says Rosie Murray-West in The Mail on Sunday. The country “had controlled the spread [of Covid-19] so well that it has been complacently slow to roll out a vaccine programme”. Still, with 37% of the population having received a first jab, it is now getting its act together.

Land of opportunity

Japan is “packed with opportunities, especially in digitalisation, robotics and electric cars”, says Chern-Yeh Kwok of the Aberdeen Japan Investment Trust. The online economy is less mature than elsewhere, says Murray-West, leaving more scope for future growth: “We may think of Japan as a land of bullet trains and robotic convenience, but it is also a country that continues to be reliant on fax machines and where only 8% of purchases are made online”. Prime minister Yoshihide Suga is trying hard to change that.

For all the doom-mongering, the Nikkei has actually grown at a compound 9.8% annually over the last decade in sterling terms, says Simon Edelsten in the Financial Times. That is behind America but better than the FTSE, Europe and even emerging markets. Japan’s economic performance has been mixed, but the stockmarket is “dominated by multinational companies”, much of whose income is earned abroad. Japan offers investors access to the Asian growth story combined with the comforts of investing in a developed market. Investors may want to take a look at the JPMorgan Japan Small Cap Growth & Income (LSE: JSGI) and the Baillie Gifford Japan (LSE: BGFD) investment trusts.

Japanese corporate governance enters the modern age

Japan’s shareholder “revolution” still hangs in the balance, says Mike Bird in The Wall Street Journal. In 2014, then-prime minister Shinzo Abe initiated a push to bring corporate governance into the modern age. He put pressure on businesses to appoint more outside directors onto boards and to focus on delivering value to shareholders. Risk-averse Japanese managers had long preferred to hoard cash rather than invest it or pay it out to shareholders as dividends.

The war is still being waged across Japanese boardrooms, says Bird. On one side, activist foreign investors; on the other, old-school managers who don’t like being told what to do. Take a recent quarrel at Yakult, the probiotic drink maker. Activist investors see an established brand with a golden opportunity to capitalise on the global wellness trend and expand overseas. Yet the firm’s board is stuffed with company insiders and “has gone from having two non-Japanese members… to having none”.

Conglomerate Toshiba was revealed this year to have “colluded with the Japanese government to suppress activist investors”, say Leo Lewis and Kana Inagaki in the Financial Times. Investors also complain that reforms designed to clamp down on cross-shareholdings – another tactic to limit shareholder influence – have been watered down.

The tide is turning in favour of the activists, says Carleton English in Barron’s. Shareholders forced Toshiba’s CEO to resign in April. Those wins are encouraging other campaigns: data from Lazard shows that Japan played host to 26% of non-US activist campaigns in the first half of 2021, up from just 6% in 2015. “Challenges at Japanese companies were once unthinkable”; now the country is becoming a “hotbed” for shareholder activism.

Welcoming “90,000 visitors from all over the world during a pandemic” to a “densely populated city where vaccinations trail Bangladesh… gee, what could go wrong?” asks William Pesek in Nikkei Asia. Japan insists that it can safely hold the Olympic games in July, but opinion polls show that more than 80% of the country’s citizens are opposed. Pressure is growing on the prime minister, Yoshihide Suga, who has backed the games. The head of e-commerce giant Rakuten, Hiroshi Mikitani, has dubbed the Olympics a “suicide mission”.

Japan has so far done a relatively good job at containing the virus, but was forced to declare a state of emergency last month in response to a new wave of cases. Uncertainty about the Olympics has weighed on markets. The Topix index has gained 7% so far this year, making it a global laggard.

Overseas investors dumped a net ¥1trn (£6.5bn) in local stocks during the second week of May, says Hideyuki Sano on Reuters, the biggest outflow since March 2020. The economic costs of cancelling the Olympics would be limited as Japan has already barred foreign tourists from attending. The games look set to deliver a stimulus equivalent to just 0.3% of GDP. That is a poor return given the risk of importing “multiple Covid-19 variants”.

Still, the long-term case for Japan is encouraging, says Simon Constable in The Wall Street Journal. The market was once shunned for its poor corporate governance, but reforms have forced Japan’s boardrooms to take shareholder value seriously. Schroders reports that the market’s average return on equity, a key gauge of profitability, has risen from 5% in 2013 to 6%-7% in 2019. That should spark more interest from global investors once the Olympics omnishambles has been sorted out.

After several decades of “false dawns” the sun is finally rising on Japanese shares, says Ian Cowie on Interactive Investor. The Nikkei 225 index has broken through the 30,000-point level for the first time since 1990. Roaring Japanese markets had dominated financial headlines for much of the 1980s. When “the music stopped” few could have predicted that it would be such a long climb back. Sadly, “quite a few long-term investors in the world’s third-largest economy” didn’t live to see this day.

A protracted post-bubble hangover

The “lost decades” after the stockmarket bubble’s implosion have turned Japanese equities into the “red-headed stepchild of global asset allocation”, says Udith Sikand for Gavekal Research. There have been moments of hope: foreign investors poured $240bn into the local market after former prime minister Shinzo Abe’s second term began in 2012. But they soon became disillusioned, withdrawing all of those funds by the time his premiership ended last summer. They shouldn’t have: corporate reforms under Abe have led to “structural improvements in Japan Inc.’s profitability”.

Don’t let the Nikkei fanfare distract from Japan’s economic problems, says The Japan Times. They range from “stunted” productivity to an overdependence on “old economy” industries. The latest rally may not have much further to run. The market may have broken through the 30,000 mark, but it remains well short of 38,957, the all-time high it reached in 1989. “Only in Japan” would analysts say things had gone too far when the market is trading “where it was 30 years ago”, Nicholas Smith of CLSA told Eustance Huang on CNBC. Few foreign investors have noticed, but local shares have been performing strongly for a while: the Topix stock benchmark has gained 125% since late 2012, outperforming many other major markets. The Nikkei 225 has soared by more than 10% since 1 January, compared with a 3.4% gain in the pan-European Stoxx 600 and a 4.2% rise on the S&P 500.

The Nikkei exorcises its demons

While 30,000 may be an arbitrary number, the “historic resonance of 1990 is powerful”, says Leo Lewis in the Financial Times. Japanese stocks have long been held back by a folk memory of the “deranged…bubble era”. In the years since, local investors could be expected to sell whenever shares rallied too much for fear of being burned again. The fact that the Nikkei has finally broken above 30,000 and stayed there suggests it is no longer overshadowed by its “manic alter-ego of 1989”.

The world has changed immensely in the three decades since the Nikkei was last at 30,000, says Graham Smith on fidelity.co.uk. Japan was then considered America’s “number-one” challenger; Chinese markets were “well off the radar for most investors”. Once eye-watering valuations have also come down, from as high as 75 times earnings in the early 1990s to 25 today – “a small discount” to global peers. The market’s stable of carmakers, electronics firms and banks is well placed to enjoy a profit surge as global recovery takes hold. “The stars seem to be aligning for Japan.”

We've long been fans of the Japanese stockmarket here at MoneyWeek magazine.It's an obvious side effect of our contrarian tendencies –it's hard to think of any other relatively mainstream asset class that has been treated with more apathy by investors in general, over the two-decade lifetime of the magazine.

So it's nice to see that Japan's stockmarket hit a bit of a milestone this morning. Again. For the first time in more than 30 years. The Nikkei 225 burst past the 30,000 mark for the first time since 1990. I mean, wow – 1990. Some of you weren't even born then.

The Nikkei is a daft index but that's no reason to ignore it

To be absolutely clear, as an index, the Nikkei has its flaws – lots of them. It's very similar to the Dow Jones index in the US from that point of view. The Nikkei has 225 companies in it – the Dow only has 30 – but they both do this rather deranged thing of ranking the stocks in the index by their share price, rather than their market capitalisation. So for example, a company with a million shares outstanding at $1 a share would have a market cap of $1m. A company with 250,000 shares outstanding at $2 a share would have a market cap of $500,000. But the latter company would outrank the former in the Nikkei (or the Dow). Because its share price is bigger.

The only reason people pay attention to the Nikkei is because it's the oldest Japanese stock index. It's been around since 1950. Again, it's the same story for the Dow Jones index. If you want to get a sensible reading of the Japanese or US markets, you shouldn't turn to the Nikkei or the Dow. You should turn to the Topix (Tokyo Price Index), which includes all of the stocks on the Tokyo Stock Exchange, and is weighted in the sensible way, by market cap. Similarly in the US, the S&P 500 is far more representative of the US market.

The counterargument to this is that, for all their flaws, people pay attention to these indices. They go in roughly the same direction as the others that represent their respective nations (indeed you might start to wonder why anyone worries about index composition). For example, the Topix hit its highest level since 1991 too. And when big headline indices hit big eye-catching round numbers, people pay attention. That's because people are people, not narrowly rational automatons. That should be pretty clear by now, given the fun and games we've seen with GameStop recently.

So, Nikkei 30,000, just over 30 years on from the first time, seems like a good moment to take stock of what's going on with the Japanese market right now.

There are lots of reasons to like Japan, but the simple rebound play is reason enough

Japan has done pretty well in terms of dealing with the Covid-19 pandemic. For reasons that don't appear to be entirely clear (in that its lockdown wasn't notably aggressive), Japan has suffered only a "modest Covid-19 toll" as the Nikkei newspaper puts it.

Meanwhile, its GDP grew at an annualised 12.7% in the fourth quarter of last year. That's a big leap. And the drop in GDP for the whole year was just 4.8%, better than during the financial crisis and better than expected by most economists. In all, the economy is pretty much back to where it was before the coronavirus outbreak. Spending has followed a similar pattern to most other places – consumers spending more on their houses, and a lot less on travelling. That solid pace of recovery has helped to boost cyclical stocks. Capital Economics reckons that first-quarter GDP will turn out to be better than anyone currently expects too. On top of that, "the recovery should get another shot in the arm from the rollout of vaccines".

There are plenty of fundamental reasons to like Japan too – slow but sure corporate governance reforms, the fact that it's one of the few big markets where there are still a lot of "value" stocks. But to be perfectly shallow about it, the rebound potential alone is reason enough. Japan is a market that tends to draw the attention of investors when they're looking for catch-up plays, so anyone who is struggling with FOMO (fear of missing out) right now and is casting about for assets that might deliver big rebounds quickly, will almost certainly alight on Japan at some point in their search.

Last year, Merryn interviewed one of our favourite long-time Japan strategists, Jonathan Allum – you can read more here. And we'll have a lot more on all of this in MoneyWeek magazine in the near future. Get your first six issues free here.

Japanese prime minister Yoshihide Suga has announced a new ¥73.6trn (£532bn) stimulus package, the country’s third so far this year. About ¥40trn (£289bn) will go towards furlough programmes, hospitals and incentives for green investment. The stimulus takes the total spent on the country’s virus to 14% of GDP.

Japan has so far dodged the worst of the pandemic, but the latest wave is its most serious, says William Pesek for the Asia Times. Japan has a serious “pre-existing condition” – about 30% of the population are aged over 65 and that proportion is rising. The debt-to-GDP ratio is more than 230% and is climbing towards 250%. “Massive national debt, a plunging population, and now, a resurgent pandemic… talk about a grim convergence.”

Upside in view

The “outlook for Japan is actually not looking too bad”, writes Robert Carnell for ING Think. More women participating in the workforce and longer careers have mitigated the “worst fears” about an ageing population. The government has been forced to step in with extra fiscal support because the Bank of Japan has run out of firepower; the central bank now owns “more than 50%” of all government debt. Its $433bn share portfolio also makes it the country’s biggest stockmarket investor. ING expects GDP to contract 5.4% for 2020 as a whole and for the economy to regain its pre-crisis level in late 2022.

Japan’s Nikkei 225 index gained 15% in November, its best monthly showing since 1994. But it remains about one-third short of its 1989 all-time peak. The Topix, which is a more accurate (if less famous) gauge of the stockmarket, is up by 3.5% so far this year.

British investors pulled £145m from Japanese funds in September, according to Investment Association data, says Jayna Rana for the Daily Mail. The wobble may have been induced by Shinzo Abe’s resignation as prime minister. They are missing out. A pro-shareholder culture is slowly taking hold thanks to Abe’s reforms, while Suga is now pushing digitalisation in a country still attached to fax machines.

The Nikkei 225 index has outperformed the US market in dollar terms this year, but few international investors have noticed, writes Mike Bird in The Wall Street Journal. Overseas buyers cooled on Abe in mid-2015 and have withdrawn funds again this year. Yet 2021 is expected to be a good year for cyclical stocks, such as industrials and consumer discretionary, which comprise “almost 40% of the MSCI Japan” index. Japanese firms also have less leverage than their overseas counterparts, which gives them a strong cash buffer for dividends – Japan yields 2.3%. When global investors cotton on, the market could soar.

Merryn recently spoke to Jonathan on the MoneyWeek Podcast. Listen to the full interview here.

Anyone who has worked in the Japanese stockmarket in pretty much any capacity over the last 25 years will have read The Blah, a piece of daily research on all matters financial and relevant to investors in Japan. It hasn’t always been called The Blah: before my time in the market (I started my career as a Japanese equity broker in Tokyo), it was briefly The Daily Bullet and then The Daily Blah, before the “daily” bit was dropped (just in case every day was a bit too hectic). It has also been written under three different corporate umbrellas (most recently SMBC Nikko). However, there has been one constant – its author, Jonathan Allum.

A few weeks ago Allum retired. I’ve long been an admirer of The Blah, partly for its general excellence, but also because Allum is one of the few people I know in the market who looks at finance through the prism of what is actually happening, rather than what he reckons should happen. Too many of us are so convinced that one theory or the other on markets must be correct that we dismiss rather more money-making opportunities than we should (John and I are guilty of this on US technology stocks, for example). Allum, on the other hand, defines himself as a classic liberal in the Robert Frost sense: “a man too broad-minded to take his own side in a quarrel”. With that in mind, we set up a Zoom meeting to talk through his 30 years in the market – and what gems (rather than forecasts…) he might have to pass on.

Japan: the future of capitalism?

I ask him what kept him focused on the Japanese market (which hasn’t exactly been popular for the last 20 years) for so long. Partly the “nagging belief that other people weren’t doing it very well”. There’s a huge amount of data available in Japan to get to the bottom of, and a lot misreporting of that data. There’s also a lot to unpack in the irritating idea that Japan is somehow different from other countries. “Japan is different from other countries in certain ways and similar to other countries in certain ways. But if you focus on the differences, I think it’s more of an... analytical dead end, because you then can’t take the insights available to the rest of the world and apply them to Japan.”

There has also long been an idea that Japan becoming less different – by which proponents mean more like the US – is a good thing and even somehow “the end destination, for a capitalist economy”. That looks like an increasingly wrong-headed way to look at things. Not only is Japanese capitalism pretty similar to that of Korea and much of continental Europe, but its “stakeholder” focus – the idea that its community, suppliers and employees matter as much as shareholders do – is now something the US and UK talk about aspiring to. “One might be slightly sceptical about whether companies are being sincere in this, but the trend, if anything, does seem to be more in the stakeholder rather than in the shareholder direction. So in that sense, we are all turning Japanese.” Perhaps it is the US and the UK that have been the outliers, not everyone else.

This isn’t just about stakeholders. It is also about financial resilience, the thing that, in an age of Covid-19 disruption, shareholders should surely be putting high up their stock-picking checklists – particularly if they are income investors. Prior to the various crises of capitalism we have seen over the last decade, Japanese firms were constantly “derided for excess conservatism” – and for holding too much cash that could have been paid out as dividends in particular. There has been an element of “survivor bias” in that: the companies that went into Japan’s crisis at the end of the 1980s with lots of debt did not survive it. But it is also a long-term reaction to the miseries of the 1990s: Japan’s managers know you need a good level of balance-sheet resilience (low debt, some cash) if you want to be sure of being around long term.

Japan has been a play on global growth

The other important thing to know about Japan, says Allum, is that for all the talk of difference, if you look at the market as a whole (using not the “barbarous relic” that is the Nikkei, but the Topix index), it basically moves in line with global GDP – and has done since 1998. Allum divides the Japanese market into three periods. There was the “rocket phase” (up like a rocket from 1980 onwards); the “stick phase” (down like a stick from the end of the 1980s to 1998 – a period sadly coincident with my time working in the Japanese market) and the “mediocre age” (1998 to now). Lots of analysts look at the market in specifically Japanese terms, but the evidence suggests that, at least at a macro level and at least for the last 22 years of the mediocre age, that’s been pointless. Japan “tends to do well when the economy is recovering or is about to recover globally and vice versa”. It is nothing but “a function of economic growth”.

On the plus side, if you take the view that we are now on the way to some form of economic recovery, within the discounting period of markets – say nine months or so – Japan would seem to be quite a good bet and “certainly has an economic sensitivity which may well be useful”.

The twist since 2005 has been that the Japanese stockmarket, in addition to moving with the global economy, has also moved with the currency. When the yen is strong, the market is weak, and vice versa. This makes some sense given that lots of listed companies are exporters, but in Japan the closeness has been “just bizarre” – and it has meant that anyone looking at the market has had to be fixated on the currency too. The good news is that there does now seem to be “a conscious uncoupling between the two”. The Nikkei has been strong, but the yen has been too. It would “be nice” if this continued and we could see Japan being “endogenously rather than exogenously driven”.

Japan: a value investor’s paradise

All this chat about markets following economic growth is beginning to worry me. For years in MoneyWeek we have told you that in the long run you shouldn’t judge a market by how you expect economies to do, but on how you expect companies to do – and crucially, how much you pay for those companies. Valuation matters. Has Allum’s experience made a nonsense of that idea? Not quite, he says. There is a cyclical component, in that in Japan in the 1980s the market boomed as the economy boomed. In the end, however, valuations did matter: however much analysts found new ways to justify them, they were not justifiable – and they crashed (as is usually the case when valuations hit extremes).

There is also plenty of long-term evidence suggesting that, in Japan in particular, value investing does give you better long-term returns. Lots of investors have used it as nothing more than a proxy on global growth, without noticing that it is also a long-term stockpicker’s paradise. “Unfortunately, as is often the case with investing, and indeed life, when you finally think you’re going to crack something it all falls apart. In the last few years, stocks that are cheaper got cheaper, stocks that are expensive got more expensive.”

That might now begin to change, I say. After all, Japan is one of the few markets left in the world that looks cheap on absolute measures. “ I would agree with that,” says Allum, who reckons that when market history is recorded, the last decade will be seen as an “aberrational period”, at least in terms of the failure of value investing. We note that Warren Buffett appears to agree. After a long time apparently considering the matter he spent $6bn buying significant stakes in five Japanese trading companies (Mitsubishi, Mitsui, Itochu, Sumitomo and Marubeni) earlier this year.

Japan should do “relatively well”

So what next, I ask. Any predictions from the safety of retirement? Allum isn’t big on predictions. The thing is, he says, that in financial markets in particular, if you are really good you will be right 55% of the time and if you are really bad it could be 45% of the time. Mostly everyone is wrong more often than not. However, he does offer a few thoughts (“with a level of modesty”, he says).

First, the strength of equities suggests a level of global economic strength that is not reflected in the super-low bond yields around the world. “My suspicion, without in any way being alarmist about... bond market collapses or interest rates going through the roof, is that the trend in interest rates will be upwards.” Not long now and the days in which the German government was able “to borrow money for 30 years for less than nothing” will look like “an enormous anomaly… bond yields will go up, bond markets will go down. And I think that’s probably good for equity markets”.

And on the Japan front? “There are great hopes for Mr Suga and his various exciting-sounding economic initiatives,” says Allum, referring to Yoshihide Suga, Shinzo Abe’s successor as prime minister. “But recent Japanese history tells us that if you have a long-serving prime minister, like Mr. Nakasone, like Mr. Koizumi, he is typically followed by a number of short-lived prime ministers. Which, given that Mr. Suga is starting his reign at the age of 71…” That’s youthful by American standards, I say. Perhaps, says Allum, but mostly it’s considered a bit “old to reach the top of the greasy pole”: he may not be around long enough to get his policies going.

Does it matter? Not really, says Allum. We agree that, in the main, markets aren’t much bothered about politics (unless there is extremism of one kind or another on the go). All in all, says Allum, Japan should do “relatively well”. It’s not quite the ringing endorsement some readers will have been hoping for – but from a man who isn’t mad for predictions, it’s still a pretty positive one.

Find out more about Arcus here

South Korean conglomerate Samsung could be “shaken up” after the death of chairman Lee Kun-hee (pictured) last week, says the BBC. Shares in several Samsung businesses have jumped amid reports that his heirs could be “forced into asset sales or dividend payments” in order to pay a “massive” inheritance tax bill.

A large tax bill isn’t the only problem that Samsung faces, says Elizabeth Koh and Jonathan Cheng in The Wall Street Journal. While Lee transformed a “second-tier electronic-parts maker into the world’s biggest manufacturer of smartphones and televisions”, the company has faced a “string of scandals and business challenges” in recent years. In particular, Lee’s attempt to pass his empire to his son, vice chairman Lee Jae-yong, who is widely expected to succeed his father as chairman, sparked continuing legal cases into “alleged bribery and financial fraud” that could see Jae-yong imprisoned. Samsung is also battling “slowing momentum” in mobile phones”.

But don’t underestimate Jae-yong or Samsung, says The Economist. Since the younger Lee effectively took over control in 2014, Samsung has defended its position in mobile devices against competition from China while also forging global partnerships, including with Apple – a Samsung subsidiary supplies the screens used in iPhones. Jae-yong is also moving the company away from producing “solid but unsexy hardware” towards an “emphasis on design and software” – the same strategy that has won American tech firms “trillion-dollar valuations”.

Not for the first time, Warren Buffett is swimming against the tide, says Mike Bird in The Wall Street Journal. Early this month his Berkshire Hathaway group spent $6bn acquiring stakes in five Japanese trading houses. Yet data shows that other foreigners have been souring on the world’s third-biggest economy.

However, Shinzo Abe, who took office in 2012 and has just resigned, leaves Japan’s markets better than he found them, says The Economist. Lower corporate taxes and a depreciating yen gave a much-needed boost to shaky corporate profits, while reforms to corporate governance have made Japanese managers more responsive to the needs of shareholders. The Topix index has gained more than 82% since he took office. Reforms in Japanese markets have been overshadowed by the dominance of US-listed tech stocks, says Andrew Bary in Barron’s. The country is “more like Germany than the US”, explains Masakazu Takeda of Sparx Asset Management. Japan’s real speciality is its “high-quality industrial businesses”, such as carmaker Toyota and air conditioning supplier Daikin Industries.

The dominance of these sectors has fed a perception that Japan is not a “sexy” investment, Nicholas Weindling of the JPMorgan Japanese investment trust tells Jeff Prestridge in The Mail on Sunday. But there are plenty of exciting growth companies. GMO Payment Gateway, an electronic payment specialist, and robotics business Keyence offer exposure to key secular growth trends. Moreover, on a cyclically adjusted price/earnings ratio of 19.4 the market looks reasonably valued. For British income seekers weary of the FTSE dividend axe, a 2.4% average dividend yield backed up by robust balance sheets looks especially appealing.

A few weeks ago we were mildly surprised to see Warren Buffett come round to our way of thinking on a few things. He sold most of his shares in Goldman Sachs and bought into gold miner Barrick Gold. As Charles Gave of Gavekal Research notes, this is a pretty comprehensive shift. Goldman is the kind of firm you own if you believe that Wall Street’s record of money-making via financial engineering is sustainable. Barrick is the kind you buy if you don’t. So the combined trades are tantamount to “selling by proxy the fiat money system” from which Wall Street’s financial engineers have long benefited.

Perhaps Buffett is “starting to short the US central bank”, something we have been doing with our gold holdings for many years – and are even more keen to do now that the Federal Reserve has fairly explicitly said it isn’t much bothered by inflation risk.

No less interesting, however, is Buffett’s new interest in Japan. Just as Shinzo Abe steps down Buffett has been endorsing his (not perfect, but pretty good) legacy by buying into all five of Japan’s major trading companies at a cost of around $6bn. This makes sense to us. Japan looks pretty cheap – the 8.6% annual rise in the Topix under Abe was driven mostly by rising profits rather than (as in much of the US) by shares being valued at higher multiples of existing profits (see page 4). Better still, says Peter Tasker, strategist at Arcus Investment, “for the first time in living memory” Japanese equities offer a “solid, real” dividend yield of 2.4%. Not to be sniffed at in a world of negative interest rates.

For investors (such as us) who worry about inflation, however, there is one more attraction deeply embedded in Buffett’s new holdings – commodities (see page 7 for more). The early phases of a reflationary environment are usually good for equities, good for commodities, and particular good for commodity-backed equities. We didn’t expect to end this phase of the crisis quite as in tune with Buffett. But this year has hardly been short of surprises.

This is not to say that pessimism rules at MoneyWeek. Far from it. We worry about valuations, so we are mildly concerned at the run up in the prices of some US tech stocks. Look at Apple’s numbers, for example, and you will see a situation that is the direct opposite of that in Japan: sales and income have barely budged in the last five years, yet its market value has quadrupled. Should Apple really be valued at more than all of the FTSE 100 – however great its products?

But that does not make us “anti”-tech. In this week's magazine, Max King looks at two tech trusts we like. It isn’t all about Apple. And I’d suggest you look again at the Blue Whale Growth Fund (70% in the US, 60% in tech). Since launch three years ago, the fund has returned 76% versus a global funds average of more like 26%. The fund does not hold the obviously overvalued stocks, so there may be more to come.

Finally, a warning. We tend to focus on making money in MoneyWeek. But it’s equally important not to lose it pointlessly. Getting caught evading tax is a silly route to poverty. Best just to pay. One example of why: the maximum fine for not declaring overseas holiday-home income is now double the tax owed. Ouch. The same goes for falling for scams. Losing money in a fund is one thing. Losing it to a criminal is another.

“The global fawn fest over Shinzo Abe’s departure takes the you-do-not-know-what-you-have-until-you-lose-it sentiment to new heights,” says William Pesek in the Nikkei Asian Review. If we take “brutally honest stock of all that Abe failed to do with his 2,800-plus days in power”, we see that just one of the three much-touted “arrows” that made up “Abenomics” was fired successfully. The Bank of Japan’s aggressive monetary policies helped deliver “the longest expansion since the 1980s” – although this failed to kick off “virtuous cycles of rising wages and consumption”. But the promise of pro-growth fiscal policies “fell to earth”, while that of massive deregulation “never got deployed”.

That may be too harsh, reckons Ma Tieying of investment bank DBS. True, annual GDP growth of 1% under Abe was only modestly higher than the 0.8% seen from 2000 to 2012. However, the “long period of political stability” (Abe became Japan’s longest continuously serving prime minister shortly before he resigned last week) at least “paved the way … to carry out some modest economic reforms”.

The concern for investors now is not whether the monetary and fiscal stimulus policies that the Abe administration has been following will change: “even without the Covid-19 pandemic, the authorities would not withdraw [these] anytime soon”. Rather, it’s whether Japan could “slip back into political paralysis or instability” with a return to the rapid turnover of short-lived leaders that preceded Abe. If so, this would present “challenges to push for further reforms to reinvigorate the economy”.

Better governance and higher profits

Still, from an investor’s perspective, a lot of important work has been done – hence many analysts think that a period of uncertainty would be a good chance to buy, says Leslie Norton in Barron’s. Abe’s attempts to overhaul the economy “remained unfinished”, but efforts to improve corporate governance have made a difference. More than 90% of listed firms have more than one independent director, compared with 20% in 2014. And cross-shareholdings between companies are now under 10% of market capitalisation, down from 30% plus in the 1990s.

Meanwhile, “little noticed even by professional investors, Japan’s earnings-per-share growth has quietly beaten most global markets in dollar terms since Abe took office”, says Mike Bird in The Wall Street Journal. Corporate profit margins, which used to range between 2% and 4%, haven’t dipped below 5% in the past five years, “suggesting a secular break in profitability”. Yet the market still looks “comparatively cheap” alongside global peers, even taking into account the shortage of “mega-cap tech companies” and the excess of “chronically troubled financial firms” among Japanese stocks.

Add on companies’ habit of stockpiling cash, which helps them avoid dividend cuts or keep investing for growth in a crisis like this, and the bull case is clear, says Richard Evans in The Daily Telegraph. Consider buying the Baillie Gifford Japan Trust (LSE: BGFD): “it is, unusually, trading at a discount” to the value of its assets.

What has happened?

Japan’s longest-serving prime minister, Shinzo Abe, in power since late 2012, announced last Friday that he would be resigning on health grounds as soon as his party could elect a successor. During a brief first spell as PM in 2006/7 Abe was seen as a conservative nationalist. In his second lengthy spell, since 2012, he has been seen as relatively pragmatic. He has provided much needed political stability, improved relations with China as well as allies in Asia (with the notable exception of South Korea), sealed important trade deals, and pursued an economic policy – “Abenomics” – aimed at restoring growth and ending deflation. His decision to step down unnerved markets, although his successor is likely to adopt a very similar policy programme.

What is “Abenomics”?

It was the attempt, from 2013 onwards, to revitalise Japan’s long-sluggish and deflation-prone economy with a “three arrow” strategy of ultra-loose monetary policy, fiscal stimulus and structural reforms. The most long-lasting of these was the sustained programme of “quantitative and qualitative” easing by the Bank of Japan under its Abe-appointed governor, Haruhiko Kuroda (who will remain in post after Abe’s departure). By 2018, after a five-year bond-buying spree, Japan’s central bank had become the first among G7 nations (and only the second after Switzerland) to own assets worth more than the whole of the national economy.

What about the structural reforms?

One of the most common criticisms of Abe is that he never delivered on his promises of deep-seated structural reforms. “It is true he never did the most radical things, such as tearing up protections for salaried staff,” says the Financial Times. “But he did liberalise Japan’s electricity market, open the country to Chinese tourists, cripple the agriculture lobby and sign two huge trade deals.” Labour-market reforms aimed at attracting more women into the workplace have been modestly successful. And Abe also introduced important corporate governance reforms, combined with a new stewardship code, that have made Japanese investments far more attractive to foreign and institutional investors. From 2017-19, Japan attracted more private-equity investments than any other country, and its level of M&A activities is second only to the US.

Did Abenomics prove a success?

Yes and no. Kuroda’s market-pleasing policy of ultra-low interest rates and bond-buying drove a rally in stocks and sent the yen lower, boosting exporters, and helping to keep growth in positive territory. Inflation picked up a little, meaning officials could declare that the long era of deflation was over. Corporate profits rose, and unemployment remained low, but in spite of Abe’s repeated urgings, those profits never fed through into wage inflation sufficiently strongly to drive a sustained boost to consumer spending. Inflation remained stubbornly below the central bank’s 2% target. Thus, on its own terms, Abenomics failed. Most notably, the anti-growth effects of raising the consumption tax from 5% to 10% outweighed the stimulus effect of great government spending. Yet under Abe both growth and employment improved, partly due to the weaker yen. And there has been no debt crisis, despite the persistent warnings of Abe’s critics (including the deficit hawks within his own party).

What else did he achieve?

Abe’s efforts benefited from propitious timing, says Ben Dooley in The New York Times. In particular, China’s economy surged during his tenure, boosting its appetite for Japanese machine tools and the specialised components needed to manufacture things such as cars and high-end electronics. In addition, Chinese tourists, “eager to spend their growing wages, flooded Japan’s cities and tourist sites, splashing out on luxury goods”. By late last year, however, Japan’s economy was contracting due to slowing global trade and the brewing trade war between the US and China, which badly hit Japanese exports. With Japanese national debt at 150% of its GDP (the highest proportion of any developed economy), Abe once again turned to a rise in the consumption tax in the hope of tackling the debt and shoring up social programmes. The tax rise killed off spending, and then a vicious typhoon devastated central Japan, compounding the economic damage. By the time the Covid-19 pandemic took hold, Japan was already in recession.

So Abe leaves on a bad note?

Indeed. Japan’s GDP fell by an annualised 28% in the second quarter, and Abe’s government weighed in with a stimulus package worth an astonishing 40% of GDP, including low interest loans and cash grants. Covid aside, Abenomics will be remembered for growing the economy, creating jobs and keeping deflation at bay, says Kathy Matsui, vice-chair of Goldman Sachs Japan. The question now is will Abe’s successor be able to tackle the remaining reform agenda items and bring Japan “once and for all out of deflation”, says Matsui. For the rest of the world – a world struggling with a slide towards stagnation, deflation and ultra-low interest rates — Abenomics offers “powerful lessons”, says Robin Harding in the Financial Times.

What are they?

The key lesson is that “monetary policy works”; the initial “bazooka” of massive asset purchases in 2013 was highly effective. “Bond yields fell; stockmarkets boomed; and most important, the yen fell below ¥100 to the dollar, a boon to Japanese industry.” Another is that “weak economies cannot handle tax hikes” and economic strength is a precondition for fiscal tightening. Abe went off course when the consumption tax rose from 5% to 8% in 2014, ultimately pushing Japan back into recession. “If you promise stimulus, and deliver restraint, you get failure,” says Harding. “That is the story of Abenomics in brief.”

Japan’s longest ever serving prime minister, Shinzo Abe, has resigned on health grounds. We’ve written about Abe and his three arrow reforms – bold fiscal policy , expansionary monetary policy and structural reform – many times over the years. It hasn’t worked out perfectly (what does?) but his leadership has seen Japan make real progress (in the structural reform bit at least).

It is hard to imagine these policies being enthusiastically reversed – particularly given that Abe’s successor will almost definitely come from the ruling LDP party. Very easy monetary policy and massive fiscal stimulus is now the global norm. That Japan was first into it is hardly evidence it will be the first to have a go at finding its way out (not everyone agrees by the way.

We would expect fiscal and monetary policy to stay pretty aggressive (the budget deficit may be obscene but the Bank of Japan will be keeping interest rates very low) and for all the attempts to improve corporate governance and so on to continue. Expect tweaks, but not much more.

In the shorter term, Japan looks like it will have a reasonably strong third quarter – daily Covid cases are falling; restrictions are being relaxed; mobility is back up with online routing requests back at pre-pandemic levels (thanks in part to the domestic tourism “Go to Travel” campaign); and the government has announced that over 98% of households have received their ¥100,000 (£700) cash handout. Hopefully they will get out and spend it – retail spending rose 13% in June and new car registrations were up 20% in July, notes Capital Economics, so they are clearly in mood.

Industrial production also looks to be coming back nicely – Capital Economics has pencilled in a 5% rise in production in July and 6.5% fall in GDP over the full year (not bad under the circumstances), but given Japan’s strong corporate balance sheets, good virus control and lack of dependence on overseas tourism that might be pessimistic.

If the change at the top – and the scramble to replace Abe – means the market sells off properly (equities were down 1.6% at their worst today), I’ll be buying more Japan in my Sipp. Few markets are cheap in absolute terms at the moment but Japan remains relatively inexpensive on most measures (cyclically adjusted P/E ratio and dividend yield in particular) and offers the now unusual prospect of long term rises in the dividend payout ratios. A key number to remember is that in July this year 56% of Japan listed companies had net cash. Only 16% of those in the S&P 500 did. In this environment, most other things being equal, which would you rather hold?

Value investors looking at Japan, try the AVI Japan Opportunity Trust (LSE: AJOT). Growth-orientated investors might look at Baillie Gifford’s Japan Trust (LSE: BGFD).

As the Japanese prime minister, Shinzo Abe, prepares to leave office, his term cut short by illness, his policies have received an unexpected endorsement: Warren Buffett, the most successful investor in history, has just revealed stakes in all five of Japan’s major trading houses. The total amount invested, $6bn, is slightly more than he recently put into gold miner Barrick.

Buffett is no stranger to Japan. Indirectly he owns the unlisted Tungaloy, which is a subsidiary of Iscar, an Israeli tool-maker. Veterans of the Japanese stockmarket will remember Tungaloy as Toshiba Tungaloy, Japan’s premier manufacturer of carbide cutting tools. Founded in 1929, the company is one year older than Warren Buffett. Iscar, now wholly owned by Buffett’s Berkshire Hathaway, bought Tungaloy in 2008.

In November 2011, Buffett made a highly publicised visit to Tungaloy’s Fukushima factory, which had been badly damaged by the devastating earthquake and tsunami. At a press conference, he had sympathetic and encouraging words for the Japanese people and noted the quality of Tungaloy’s operations.

However, what he did not do was make any investments in Japanese stocks. This was unsurprising. At the time, corporate Japan had a poor record of sustained profitability, the economy having experienced two “lost decades” of deflationary stagnation after the bursting of the bubble economy.

Buffett is nicknamed “Snowball” – also the title of a fascinating biography of the man – because he believes in the concept of compounding, one of the foundational concepts of value investing. Just as a small snowball can grow larger and larger as it rolls down a hill, so constant good returns can accrete into a large sum over time.

Japan has changed in the last decade

As of 2011, there were no large companies with records solid enough to match Buffett’s criteria. Things are very different now. In his statement, Buffett was unusually effusive, declaring himself “delighted to have Berkshire Hathaway participate in Japan’s future”, and hinted at exploring co-investment opportunities and increasing his stakes in the trading companies later. He also made it clear that this was his personal call, not a decision by one of his portfolio managers.

Prime Minister Abe must have been happy to hear the news. Back in September 2013, he rang the bell for the start of trading at the New York Stock Exchange and exhorted investors to “buy my Abenomics”, referring to the package of reflationary measures that he had introduced at the start of that year.

It was a bold calculated bet, establishing that the performance of the Japanese stock market would be a crucial measure of Abe’s success. No previous Japanese leader had elevated the stockmarket in such terms. Indeed, politicians in most countries are wary of commenting on stockmarkets because their gyrations are so unpredictable.

In normal circumstances, such caution is sensible. But when the Abenomics bull market started in November 2012, economic conditions in Japan were anything but normal. After two decades of chronic financial crisis and deflationary stagnation, Japan’s nominal GDP was no higher than it had been twenty years previously and the Topix index of stock prices was languishing at roughly the same level as in 1983. As far as international investors were concerned, Japan had dropped off the radar screen.

Put simply, Abe’s plan of resurrecting Japan as a confident, independent geopolitical player would never succeed without economic revival – and that could not happen without a decisive end to the long drawn-out bear market in stocks.

How Abe’s record stands up

So now that the Abe era is coming to an end, how does his record stack up? Between December 2012 and September 2020, the Topix produced an annualised total return (including dividends) of 8.6% in dollar terms. That is a far cry from the 14.7% generated by America’s S&P 500 index, which has been in one of the longest and strongest bull markets in history. However, if we compare Japan’s performance with the 5.9% generated by the rest of the world – as measured by the MSCI World ex USA index – it looks highly creditable.

Furthermore, the rise in Japan’s stockmarket has been driven by improved corporate fundamentals, not any inflation of valuations. From 1954 to 2012, Japanese profit margins moved in a 1% to 4% range, which is exceptionally low by international standards. But as of 2019, margins had soared to 6%. The biggest improvement was not in the export sector, but among the overwhelmingly domestic non-manufacturers, as sectors such as construction stopped taking on low-margin work.

The valuations speak for themselves. Until Covid-19 burst upon the scene, the Topix’s price/earnings ratio was at 50-year lows. The current price/book-value ratio of 1.17 tells a similar story. And Japanese book value is mainly backed by tangible assets, including a vast stockpile of cash, rather than the “goodwill” from M&A activity and other intangibles that makes up 70% of US book value.

Japanese stocks now offer a solid dividend

Likewise, for the first time in living memory, Japanese stocks are offering a solid real dividend yield of 2.4%. Pre-Covid, this was enhanced by share buybacks amounting to between 1% and 2% of market capitalisation. Japanese pay-out ratios are still low by European – let alone American – standards, so more progress is likely if and when corporate confidence recovers from the Covid shock.

Abe was not directly responsible for all these changes in corporate behaviour, but his espousal of governance reforms changed the weather in terms of the relationship between company managements and investors. Japan’s stewardship code and governance code are not compulsory, but peer pressure is a powerful force.

Today, nearly all listed companies have investor relations departments and most are willing to answer in-depth questions about company operations. This was far from the case in the early years of this century. In a poacher-turned-gamekeeper move, some companies have recruited ex-investment bank personnel to staff their IR departments. A few are foreigners, which, again, would have been unthinkable in former times.

Abe also converted the Government Pension Investment Fund from a sleepy backwater, whose main function was hoovering up Japanese government bonds, into a sophisticated multi-strategy asset manager. The GPIF, usually reckoned to be the world’s largest pension fund, is now a trailblazer for governance reform and ESG principles in Japan and a role model for other domestic pension funds.

Abe’s record is by no means flawless. Two unnecessary hikes in the consumption tax, the last enacted just as the Covid virus was emerging in China, crushed the economy’s reflationary momentum. Inflationary expectations – as measured by five-year inflation swaps – have round-tripped from sub-zero to 1.4% and back again. All the monetary policy innovations of Bank of Japan governor Haruhiko Kuroda were for naught without expansionary fiscal policy working in tandem.

Overall, though, Abe leaves Japan’s investment scene in far better shape than he found it. If his successor continues in the same vein – hopefully adding fiscal policy to the mix – investors should be well pleased. Warren Buffett seems to think so too.

• Peter Tasker is a strategist at Arcus Investment.

Japan has dodged the worst of the pandemic, but its economy has not been so lucky. Despite its relatively elderly population, death rates from Covid-19 have been among the lowest in major countries. Yet the world’s third-largest economy still entered a recession in the first quarter.

More bad data is on the way; economists predict a 20% annualised slump in GDP for the second quarter, which coincided with a national state of emergency.

The economy has been gradually reopening since the end of May, with finance minister Taro Aso declaring that activity “seems to have hit bottom”. The benchmark Topix stock index is down 6% so far this year, but has rallied 28% since a mid-March low.

Lavish stimulus

Japanese policymakers have responded to the downturn with aggressive stimulus measures. The central bank, long a monetary innovator, has pledged to buy a maximum of ¥12trn (£88bn) in stock exchange traded funds (ETFs) this year. Previous purchases mean that the Bank of Japan already owns roughly 8% of the country’s entire equity market, says Scott Longley for etfstream.com. The bank has also pledged to take its stock of corporate debt up to ¥20trn (£150bn). Politicians are also testing “the limits” of fiscal stimulus, says The Economist. Tokyo has pledged $2.2trn in support, including loan guarantees – equivalent to 40% of the country’s entire GDP.

Japan’s government debt is already the world’s highest at 240% of GDP and is heading higher still. The wall of budgetary “red ink this year tests the limits of comprehension”. Yet with the central bank backstopping government bond prices, markets have simply “yawned in response”.

Overshadowed by the surge on Wall Street, Japanese shares have been quietly outperforming European and emerging markets this year, says Mike Bird in The Wall Street Journal.

On a forward price/earnings ratio of 15.7, stock valuations remain reasonable. Japanese companies look like a two-way bet. If a global recovery takes hold then Japan’s export-orientated electronics and communications businesses will enjoy a surge. But if growth stays weak then the mammoth ¥280trn (£2trn) corporate cash mountain is a mighty bulwark.

Those cash reserves underpin the country’s attractions as a dividend destination, says Moxy Ying on Bloomberg. Japanese stocks currently yield an average 2.5%, similar to major continental bourses and much better than the S&P 500. Robust balance sheets, dividends and “political stability” are the key attractions, says Societe Generale. The bank thinks that the Land of the Rising Sun looks like the “perfect place to be”.

“The Japanese stockmarket is like a toxic blowfish,” writes Leo Lewis in the Financial Times. It has repeatedly proved to be “delicious only to fanatics”, while being “absolutely riddled with danger”.

Japanese equity connoisseurs were in for another nasty surprise this week. The Nikkei 225 index plunged by 4.5% on Tuesday. That caps a long period of underperformance. The Nikkei has gained 20% in five years, while America’s S&P 500 has jumped by 50%. At 22,600, the Nikkei is still far short of the 39,000 mark it reached in 1989 bubble.

An economic shocker

Japan’s economy recorded its biggest contraction in five years in the fourth quarter of 2019, reports Akane Okutsu in the Nikkei Asian Review. An ill-timed sales-tax hike and a typhoon contributed to an annualised 6.3% plunge in GDP. The 2% rise in sales tax provoked a 11.1% tumble in consumer spending.

“The sun may yet rise on Japan’s stockmarket,” writes John Higgins in Capital Economics. The underperformance of Japanese stocks has been a long-running trend, but the headline numbers can be deceptive. Since the start of 2010 the gap in cumulative returns between the US and Japan has averaged 6.3% annually. Recent underperformance can partly be blamed on a depreciating yen, which depresses returns in foreign currencies. An even bigger factor is simply the fact that American stock valuations have increased more rapidly. Japan’s post-crisis growth in earnings per share has actually been slightly faster than America’s.

The result is that equities are cheap. On a price/earnings ratio of 15.9, Japanese stocks are among the most reasonably priced in the developed world. Those hunting for yield will be pleased by the 2.4% dividend yield, higher than America’s and comparable to that offered on major continental bourses.

The rise of payouts to shareholders in Japan confirms that the days when the country’s managers cultivated a reputation for “penny-pinching and hoarding cash” are at an end, says Mike Bird in The Wall Street Journal. Prime Minister Shinzo Abe has ushered in corporate governance reforms that have made shareholder value a priority. The result is that buybacks surged 48% in this fiscal year.

Corporate Japan can well afford to be generous. Non-financial firms are “perched atop” a ¥285trn (£2trn) cash mountain. This is a market characterised by “low foreign ownership, relatively cheap valuations, and an increasingly shareholder-friendly policy”.

Investors with a “long time horizon” should ignore the short-term turbulence and “consider a significant allocation to Japan”.

Here's something interesting an article in the FT that is supportive of the Japanese stockmarket but that isn't written by me. Leo Lewis is looking at Japan and seeing some good stuff.

There are record dividend payouts and there is a guaranteed buyer (the Government Pension Investment Fund and the central bank are huge buyers). There's a big new buyer in town too with the introduction of negative interest rates, buybacks are suddenly running at levels well above any previous year (this by the way was exactly the mechanism by which very low rates in the US have given us equity bubbles). Add up the total these three players will buy this year, says Lewis, and you come out at around 23bn.

There is also rising evidence that Abenomics is not dead (or at least, says Jonathan Allum in his Blah newsletter, that it is refusing to lie down). Most recent data has been full of pleasant surprises. So why then are foreign investors selling? Lewis says they have sold around 10trn of Japanese stocks in the last 12 months alone.

It seems that "all they can see is ugliness". That makes some sense there is uncertainty around zero interest rate policy and around the huge intervention into the markets by public bodies. But in the end, stock prices come down to two things price and the flow of money. Japan is not expensive (down 15% in the last year) and certainly not relative to the likes of the S&P500.

Our old friend Hugh Hendry of Eclectica is with Lewis on this. He is buying. People have been predicting that the currency would collapse for years, he told Citywire Wealth Manager. But it hasn't happened. Nor has the long-forecast collapse of the bond bubble. What's more, reckons Hendry, it isn't going to happen something that gives Japan pretty much free rein to keep on printing money and buying assets in its bid to create some kind of inflation. All good for equities.

How should you get in? We've looked at lots of different funds in the magazine over the years, but at the moment I am particularly interested in one of the things mentioned above record payouts to shareholders and hence in the launch of various new funds around this theme.

One of the newest is the Baillie Gifford Japanese Income Growth Fund. Its starting portfolio yields 2.5% (very good for Japan) and if you get in in the next three months you will pay a management fee of 0.25% for the next 12 months (after that it goes up to a still reasonable 0.65%). Baillie Gifford has an excellent record in Japan (I sit on the board of the Shin Nippon investment trust which has delegated its fund management to them) and that, I think, makes this new fund worth a look particularly at this price.

The world is slowly getting more mad than we could possibly have imagined eight years ago (and regular readers will know we have pretty crazy imaginations at MoneyWeek).

Look at Japan, where the private sector is slowly turning into a massive public sector. The Bank of Japan (BOJ) has long been known to be the major holder of Japanese Government Bonds (JGBs). But since it started its turbocharged money printing programmes it has also become a huge holder of the nation's equities (if you print money you have to buy something with it ).

As a note from Halkin Services points out, the BOJ is now a top ten shareholder in about 90% of the Nikkei 225 Stock Average. As a result of its massive purchases of exchange traded funds (ETFs), it holds more than half of the entire Japanese ETF market.

It now owns more Japanese blue chips "than either BlackRock, the world's largest money manager, or Vanguard Group", with about 9% of Fast Retailing, the operator of Uniqlo stores, and nearly 5% of soy sauce maker Kikkoman Corp, for example. And there is more coming.

The governor of the BOJ reckons that its presence isn't yet "too big". Goldman Sachs reckons that the BOJ could accelerate its spending from the current level of 3.3trn to 10trn or so. That, says Halkin, could make it the number one shareholder in about 40 of the Nikkei's 225 companies by the end of next year.

The Bank isn't ending up with much in the way of smaller companies it uses large cap ETFs so it doesn't yet control a large percentage of the overall market capitalisation of Japan (it still holds under 2% overall). But this still matters.

Read my interview with Mervyn King in this week's magazine and you will see that he worries hugely about central banks overstepping the democratic mark: their managers aren't elected, so they have to be very careful not to do anything that works as fiscal policy (redistributes resources, or affects asset allocation). My guess is that he would think Japan has done that.

It is hard to imagine the BOJ ever selling this volume of equity back into the market, so we have to now see it as a long-term and committed holder of Japanese equities. Buying ETFs rather than stocks prevents the BOJ from becoming directly involved in the governance of individual Japanese companies, but it still gives it a say on overall governance. And as Halkin says, "even targeting funds that favour particular types of firms may drag the central bank into small-scale decisions about resource allocation." See how financial crises erode democracy? It doesn't take long.

All this also begs a question that John Stepek asked me that I can't answer what happens when the Bank of Japan owns everything in Japan? Answers below please.