Japan: Weathering the storms

The Japanese market has recently witnessed one of the most significant three-day drawdowns in its history. Such sharp declines are usually associated with major and unexpected economic events, like the Lehman crisis, the great Eastern Earthquake, or the COVID-19 crisis. However, this time, it appears more akin to the butterfly effect, influenced by complex global cross-asset correlations rather than an unforeseen economic calamity. This situation is reminiscent of 1987 rather than 2007.

Market volatility and immediate impact

The Bank of Japan (BOJ) recently increased its policy rate from 0-0.1% to 0.25% at the end of July 2024[RN1] . Despite indicating a possible rate hike since December 2022, this move was slightly more hawkish than consensus expectations. Concurrently, economic releases in the US led to a dovish shift in Federal Reserve (Fed) funds expectations, even though the Fed itself did not make any statements. This confluence caused significant movements in foreign exchange (FX) markets, leading to a strengthening yen. As these events unfolded, short-term volatility and contagion surged, with Japanese equities at the forefront, followed by ripples across regional equities in Asia. The long-short equity community, in particular, appears to have rapidly unwound exposures.

Interpreting the market signals

What can we deduce from these market moves? Fundamentally, not much has changed. It is fair to say that global markets are more concerned about US growth, given its status as the world’s largest economy. In Japan, the market has finally realized that interest rates will not remain zero indefinitely. Beyond these observations, the market movements seem more reflective of financial market positioning rather than a fundamental shift in economic reality.

Despite the unusual volatility, sentiment on the ground in Japan remains relatively calm. The Japanese economy continues its path of structural improvement, particularly in the listed corporate sector. Stock market earnings remain solid, thanks to genuine self-help and ongoing structural reform of business models and capital policies. Earnings grew by approximately 12% in the last financial year, and the current fiscal year appears to be off to a strong start.

Evaluating recent trends and looking ahead

The bull market in Japanese equities that started at the beginning of 2023 slowed down in the second quarter of 2024. The MSCI Japan Index is up about 56% since the start of 2023 (in yen terms) but following a blistering 20% total return in the first three months of this year, it gained around 2% in a quieter second quarter.

After the slowdown in the past quarter, one might question whether the market has run out of steam. Reflecting back to 2022, a year marked by global recession fears, Japanese companies still achieved an 8% net profit growth, demonstrating resilience. This resilience, coupled with the Bank of Japan’s shift in monetary policy and significant investments from prominent figures like Warren Buffett, has set a robust foundation for the market's performance.

The MSCI Japan Index’s 56% total return since the end of 2022 is underpinned by an earnings growth of around 20% over the same period. Despite rising valuations, they remain reasonable in our review, with the forward PE of the market (Topix Index) at just under 16x. This broad-based market performance spans various sectors, from financials and autos to machinery and services, indicating a well-rounded growth story.

Looking forward, Japanese equity returns are likely to be driven by earnings per share growth and dividends. The consensus forecasts a further 12% net profit growth for the current fiscal year¹, with dividend payments continuing to grow at double-digit rates. This positions the market for solid local currency returns with relatively modest risk.

One notable risk is the yen's volatility. The yen’s recent fluctuations against the dollar underscore the need for market participants to brace for potential rate adjustments. Despite this, we believe that USD-based returns from Japanese equities could see significant gains in the coming years.

The recent market volatility, while unsettling, offers investment opportunities. The Japanese market, with its ongoing structural improvements and robust earnings potential, remains an attractive proposition for investors. We remain committed to identifying value and capitalizing on market dislocations, ensuring a balanced and strategic approach to navigating these dynamic times.

*This article was first published, in Chinese, in the Hong Kong Economic Journal.

¹Sources: Nomura research, “Japan stocks to sustain allure amid structural and policy reforms’’

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