The tide finally turns for Japanese stocks

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It has taken 33 years, longer than almost all fund managers have been in the industry and, in fact, longer than some of them have been alive. But finally, the Japanese stock market is back in business.

The question, of course, is whether it will lead hapless international investors to disappointment yet again. In this regard, one key thing to watch out for is the yen.

The country’s Topix stock index this week maintained its slow and steady rise, and struck its highest point since August 1990. It’s still nowhere near the dizzying heights it reached in Japan’s epic asset bubble of the late 1980s: 25 percent or so left before the market returns to that beak.

Still, the market hasn’t rallied in this territory since turtle power it went to the top of the UK charts. (If that doesn’t have you humming ‘teenage mutant ninja turtles’ to yourself for the day, you must have been shielded from this pop aberration by good taste, geographical distance, or youth.)

Japanese indices are among the best-performing national benchmarks in the world this year, with the Topix gaining nearly 14 percent and the Nikkei 225 gaining 18 percent. That tops the gain of nearly 10 percent in the US S&P 500 and also stands out among another rare buoyant run in Europe: the Euro Stoxx 600 is up 10 percent, but France and Germany can still top that, with around 16 and 17 percent respectively.

Giving the rally more durability, it comes from a variety of sources, including an accelerated revamp in corporate governance and a determined effort to clean up perplexing corporate cross-holdings, plus a slew of no’s. Japan is economically sensitive to a post-lockdown China, of course, but it’s not China, so it’s not under the same geopolitical or regulatory shadows.

Nor is it the US, which is dominated to an alarming degree by a bunch of tech stocks with outlandishly high valuations. Fun fact: Apple is now worth more than the entire Russell 2000 index of smaller US companies. Some investors are spooked by this degree of concentration and are drawn to Japan’s relatively low valuations.

For long-suffering Japanese market specialists who have been waiting for a comeback for years, this is great news. Yes, the S&P 500 has added around 1000 percent in the time it has taken the Topix to finally recover its 1990 levels. But many investors are understandably excited, and some dare to utter the words “this time is different.”

Eddie Cheng of London-based US asset manager Allspring Global Investments agrees with the big rally in Japanese stocks. He likes the still low valuations and low country stock index weightings in sectors that have struggled globally of late, banks in particular.

The Topix is ​​trading at an aggregate price equal to 16 times its earnings over the previous 12 months, compared to 20 times for the S&P 500 Index and just under 18 times for the MSCI World Index.

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But in the medium term, he describes himself as “much more cautious.” For him, the key reason why Japanese stocks have performed well of late is the huge gap in monetary policy between Japan and, well, pretty much everywhere else.

The US Federal Reserve, the Bank of England and the European Central Bank have launched historically aggressive interest rate hike campaigns over the past year, while the Bank of Japan has stood cool and alone, keeping the prices nailed to the floor and buying government bonds. to keep yields under strict control.

Among other effects, this has pushed the yen to some of its weakest levels in two decades. The dollar has pulled back from its peak above 150 yen in late 2022, but is still at 138 yen or so. That makes Japan more of a bargain for foreign investors.

The danger is that the spread could narrow if Japanese inflation turns out to be stronger than the BoJ expects and if there is a US recession, forcing the Fed to cut rates. Both are great determining factors but also plausible results. If they come to pass, the pillar of yen weakness that plays a big role in boosting Japanese stocks could quickly unravel. The yen also serves as a typical safe-haven currency, so the tail risk of a US debt default could easily trigger it.

Investors are also pointing to another potential hurdle: what if the corporate governance revamp falls victim to its own success? A fund manager says Japanese authorities could easily get what he called a case of “heebeejeebies” — or an outburst — if big foreign companies took advantage of Japan’s weak currency and improving corporate governance. to take over companies on the fly. cheap. “That’s the biggest fear, that it’s too much too soon,” he said.

All of this may reflect excessive caution among fund managers looking for reasons to worry. Even if the BoJ did tighten on monetary policy, for example, it would almost certainly be a long, slow process rather than a sudden shock that sent the yen soaring. But the search for problems is perhaps inevitable after so many false dawns.

katie.martin@ft.com