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.
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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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