Japan’s long-awaited recovery

October 13, 2023

Yasaka Pagoda behind an alley in Higashiyama, Japan.

Japan has been quite cautious with pandemic control. Only on May 8, 2023 did the government downgrade COVID-19 to the same level as seasonal influenza. The country’s Q2 GDP grew 1.2% quarter-on quarter, outpacing market expectations, mainly driven by a rebound in exports and an increase in tourist arrivals. Japan boasts the world’s largest electronics industry and ranks third in automobile production. Real wages have turned positive for the first time in seven quarters and corporate appetite for investment was solid. 

In September, two of our team members participated in investment conferences and conducted company visits in Japan. Business operations in the country are back to normal. Inbound tourism is visibly booming. Making a reservation at a restaurant is a must. In August, about 2.2 million foreign visitors travelled to Japan, representing 85.6% of the visitors seen in the same month in 2019. For context, about 32 million foreign tourists visited Japan in 2019 and spent a record high of ¥4.8 trillion

Behind these short-term recovery signs, there are also indications of some long-term structural changes that lead us to believe that Japan is at inflection point and shifting from a deflationary to inflationary environment.  

Japan inflation rate

These structural changes include: 

  1. Notable improvements in balance sheets. Historically, Japan’s prolonged deflation was triggered by the 1990s real estate bubble burst. This caused a credit crunch and a liquidity trap, essentially resulting in a balance sheet recession. Now, both property prices and corporate balance sheets have been on a consistent growth path.
  2. The Yield Curve Control (YCC), having faced challenges, is likely to be phased out in the coming months. Introduced in 2016 by the Bank of Japan (BOJ) to combat deflation, YCC’s objective was to maintain low yields to stimulate consumer and business spending. This approach worked well when inflation was low because investors could enjoy the safe returns of government debt. But with inflation eroding those gains since the spring of 2022, investors have started to sell government bonds, pricing in the chance of a near-term rate hike. To maintain this framework, the BOJ intervened by buying bonds, to little avail. In December 2022, the BOJ doubled the band to allow the 10-year yield to move 0.5% above or below zero. Nevertheless, the 10-year Japanese Government Bond yield recently rose to 0.805%, a decade high. Many economists now expect the BOJ to discontinue the YCC within the next six months. We agree with this view and think the next logical step is for the BOJ to raise its short-term policy interest rate from -0.10% to 0%, given that inflation, largely attributed to wage growth, seems persistent.

  3. Wages are on the rise again, a trend that should continue, driven by a severe long-term labour shortage. Japan may face a shortage of more than 11 million workers by 2040. Wage negotiations, particularly between major corporations and Rengo, also known as the Japanese Trade Union Confederation, are under close watch. The average wage hike was 3.58% in April 2023, the highest in three decades. For April 2024, the estimate is another hike of around 3%. 

Japan’s stock market has recently reached a peak not seen in 30 years, with the Nikkei 225 Index up 19% year to date. Warren Buffett’s investment in five Japan-based trading companies provided a vote of confidence, indicating Berkshire might own as much as 9.9% of each of these companies. Many investors are attracted by cheap valuations, the return of inflation and a depreciated yen. 

Early this year, the Tokyo Stock Exchange urged companies to boost their price-to-book (P/B) ratios. Half of the companies listed on the Tokyo Stock Exchange trade at a P/B ratio of below one, compared with just 3% of firms on the S&P 500 Index. As highlighted earlier, businesses now have solid balance sheets, positioning them to enhance shareholder returns. In the fiscal year 2023, the dividends and share buybacks of companies on the Nikkei 225 were at record levels. 

Historically, Japanese small caps have outperformed large caps over the long term. However, since 2018, persistent macro uncertainties have swayed investors towards the relative stability of large caps.  

Japanese small caps outperforming large caps (through Aug 2023) 

Source: Nomura based on Nikkei 

We believe Japanese small caps are poised to outperform, mainly due to three reasons.  

  1. Historically, small caps outperform during economy expansions thanks to their better growth potential.  
  2. Small caps are expected to have accelerated profit growth in the fiscal year 2024. As of October 6, 2023, the EPS of MSCI Japan Small Caps is expected to rise by 11.6% compared to the 6.5% growth expected for its large peers. 
  3. Small-cap valuations are nearing historic lows compared to large caps, the biggest discount in 11 years. 

Source: Nomura, based on Toyo Keizai.

You may be curious about the impact of rising interest rates on our portfolio. Reassuringly, half of our Japan-based holdings are in a net cash position and the remainder carry low debt. A strong balance sheet has consistently been a key factor in our stock selection process. What’s more, to benefit from rising interest rates, this year we initiated a position in Concordia Financial Group (7189 JP), Japan’s third-largest regional bank, because we believe its growth will accelerate in a rising interest rate environment 

Amid Japan’s profound economic changes, we remain vigilant and adaptive, constantly refining our strategies and insights to help ensure that we navigate this evolving landscape in the best interests of our investors. 

Global Alpha Capital Management Ltd.
October 13th, 2023