Why are investors buying Japan again?

JAPAN’S renaissance as a destination for foreign capital might be counted as among the biggest surprises of the year so far. This month, the broad based Nikkei 225 Index overtook even Europe’s surging stock market indices to become the year’s best performer among developed markets¹. 

While still well short of its record high, at just over 31,000, the Nikkei is back to its best levels since 1990².

Key to this change in fortunes has been an improved growth outlook. According to the IMF earlier this month, Japan’s economy is anticipated to grow by 1.3% this year and 1.0% in 2024 – so faster than Europe and almost as quickly as the US over the next two years³.  

Admittedly, the competition is not fierce. Much of the western world is labouring under sharp increases in interest rates and the recession debate is running hot. Even so, it’s been quite some time since Japan was this close to the top of the growth leaderboard. 

Crucially, inflation has been making a comeback, reaching 4.3% in January. Consumer prices have moderated a little since then, but were still 3.5% ahead in April on the same month in 2022⁴.

Japan differs significantly from most other countries in that inflation is highly prized. For much of the past three decades, the country has been mired in reticent consumer behaviours and bouts of deflation. Only recently have these spectres been laid to rest, how permanently, we do not yet know.      

The current economic picture differs significantly from the weakness that has characterised Japan ever since rising interest rates burst an immense asset bubble at the end of the 1980s. 

The remarkably long intervening period between 1989 – the year when the Nikkei peaked at a record high of almost 39,000 – and today spans a period during which Japan has struggled to adjust to the bursting of its 1980s asset bubble. 

Generally weak consumer demand, bad debts from previous excesses and the costly reform of outdated corporate structures drove extended periods of sub-par economic growth and deflation. The Nikkei dropped well below the 10,000 level several times along this difficult path.

Japan’s recent transition from deflation has been helped in no small way by its emergence from the pandemic. The services sector is now driving employment higher, in a labour market which was already short of workers. Japan’s unions won overall pay gains of 3.7% in spring negotiations, meaning wages now have a chance of growing in real terms this year⁵.

This foretells a possible return to more normal conditions, where consumers no longer need to be inclined to defer purchases in the expectation of lower prices tomorrow. It will take some getting used to for generations who have saved rather than spent wherever possible.

That means Japan’s central bank has options. Under the direction of its new governor Kazuo Ueda, it could move to return inflation to its 2% target. Equally, it may decide not to. As in the west, high base effects will tend to edge inflation lower in a year’s time. 

Most importantly, the desire not to engineer a return to the falling consumer prices of the past will be very real. The Bank of Japan is already in a process of reviewing monetary policy that’s expected to last until the end of next year. That reduces the chances the central bank’s main interest rate – currently below zero – will be raised anytime soon.  

Japan also has another big factor in its favour – valuations. Whereas the US stock market continues to trade close to its pre-pandemic peak in terms of price and multiples of company earnings, Japan remains inexpensive compared with both its own history and world markets.   

By way of illustration, the MSCI Japan Index trades on just 13 times the earnings companies are expected to make over the next 12 months compared with 16 times for world markets⁶. That’s less than a third of the 40 times forward earnings the stock market was trading at in late 1989, and only about a sixth of the 75 times seen after corporate earnings collapsed in the early 1990s⁷.

The low valuations of Japanese companies have become a source of domestic concern and, under new governance rules, businesses are now being compelled to improve shareholder returns. Some have been doing this by buying back their own shares; others through higher dividend payouts. Dividends rose to a record high last year⁸.

It’s also worth remembering that Japan’s legendary expertise in machinery and electronics manufacturing bodes well for a future set to be shaped by technological advance. 

In areas such as electric vehicles, artificial intelligence, robotics and many others, Japan has the proven capabilities to turn ideas into reality. It may be that 2023 turns out to be the year that Japan, once more and belatedly, also returned to being the default choice for investors in Asia. 

Fidelity’s Select 50 list encompasses three funds dedicated to Japan. 

The Baillie Gifford Japanese Fund is an actively managed portfolio with a bias towards large Japanese companies.  It aims to deliver growth over the long term and draws upon the expertise of the largest team of Japan specialists outside Japan. Current large holdings include the conglomerate SoftBank; Sony; and the financial services group SBI Holdings.

The iShares Core MSCI Japan Fund offers a wide-ranging, agnostic exposure to Japan. Run by BlackRock, a seasoned passive funds manager, it is designed to track the MSCI Japan Index and benefits from a low ongoing annual charge of just 0.15%.

The Schroder Japan Trust has an entirely different approach. This is an investment trust run by a team based in Japan with a very strong research capability. It has a contrarian approach, seeking out opportunities to invest in companies that are out of favour with the market, and generally invests in about 50 to 60 companies at a time. 

Being a closed ended investment trust, it can borrow to invest, which can be very cost effective in Japan’s low interest rate environment. This trust currently trades at a 10% discount to the value of its assets, compared with 13% at the end of last month⁹.    

For more on Japan, watch Tom Stevenson’s latest Investment Outlook video below.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. The shares in the Schroder Japan investment trust are listed on the London Stock Exchange and their price is affected by supply and demand. The investment trust can gain additional exposure to the market, known as gearing, potentially increasing volatility. The Schroder Japan Trust also invests in a relatively small number of companies and so may carry more risk than funds that are more diversified. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.