Over three decades since Japan’s economic bubble burst, its economy has turned a corner, heralding a potential long-term bull market for Japanese equities. With the Nikkei 225 Index charting new highs, Kenny Arnott and Yianni Gertos discuss the Macro and Micro drivers, as well as the investment themes they have identified fuelling the optimism surrounding Japanese equities’ future prospects.

Key takeaways:

1. After more than three decades, Japan’s economy has finally turned a corner.
2. Both supportive Micro and Macroeconomic factors could mean the dawn of a new era of economic prosperity and a secular bull market for Japanese Equities.
3. Three asymmetric trends and one looming threat have been identified, bringing new opportunities for active investors in a shifting economic landscape.

 

After Japan’s powerhouse economy ground to a halt in the early 1990’s, what followed was a three-decade period of economic stagnation in what has come to be known as the ‘Lost Decades’.

This now seems to be coming to an end as a supportive mix of Macro and Micro forces look set to propel the economy forward, setting the scene for a secular bull market for Japanese Equities.

Macroeconomic drivers fuelling growth

Japan appears to have now exited the Lost Decades, achieving nominal GDP growth and finally moving away from long-term deflation.

This growth revival is no accident; however, it is the culmination of a prolonged period of successful government policy. This began in 2012 with ‘Abenomics’ and has been accelerated by the current administration’s efforts in seeking to create a virtuous cycle of economic growth driven by wage growth and corporate capital expenditure.

Accelerating these trends is Japan’s unique position in the ‘multipolar world’. Japan is a global manufacturing powerhouse, with stable rule of law and deep economic ties with the United States and allies.

Japan has emerged as a supply partner of choice, as corporates seek to diversify their supply chains away from regions which may be at risk of geopolitical tensions, boosting inbound investment.

Japanese corporate profits are now on the rise, giving impetus to Japanese companies to invest in Japan, providing more fuel for growth.

The Microeconomic forces that held Japan back

After the bursting of the bubble in the early 90’s, Japan Inc. went into an extended period of deleveraging, seeking to hoard cash and refrain from investment. While short-term this can be essential for business survival, for shareholders over the long-term, these initiatives ultimately drove negative outcomes, resulting in declining shareholder returns and a reduction in corporate profits due to insufficient investment.

This approach wasn’t limited to corporate Japan, it was also mirrored in Japanese households, where 54.2% of household assets were held in cash. For context, this compares to 12.6% in the U.S. and 35.5% in the E.U.

The result of high levels of savings and low levels of expenditure across an economy is exactly what we came to associate the Japanese economy with over the past three decades – an economy that is sluggish, anaemic and systemically broken.

This trend is changing, however, with The Tokyo Stock Exchange (‘TSE’) seeking to accelerate corporate governance reform with a slew of initiatives focusing on cost of capital and profitability.

This is positive for shareholders and will likely result in an acceleration of the expanding corporate profits in the years ahead as the TSE continues to push ahead with reform agendas.

Three emerging asymmetric opportunities

1. Exit from the period of deflation: With the Japanese economy growing in nominal terms, sustained wages and increasing corporate capital expenditure, we are likely to see a period of sustained inflation. This creates a series of opportunities, the most asymmetric of which, we believe, is in being short Japanese Government Bonds, at interest rates of less than one percent.

 

2. Corporate Reform Beneficiaries: Japan is home to some phenomenal companies, with world-leading products and services, driven by a relentless pursuit of “Kaizen” – continuous improvement. This has not translated into shareholder returns, with profit margins, return on equity (ROE) and return on invested capital (ROIC) measures trailing well below fellow developed nation peers. We believe that the new wave of corporate reform spreading across Japan will drive a material uptick of profitability for Japanese corporates, which have prioritised stakeholders over shareholders for the past thirty years.

 

3. IT & Capital Expenditure Beneficiaries: Productivity growth is high on the agenda for corporate Japan. With a rising profit pool, we believe the propensity to spend increasing capital on IT systems upgrades and plant and equipment to lift operating efficiency is rising. This provides a long tail of potential winners from this trend.

What happens when Japan’s capital comes home?

With increasing domestic returns and greater foreign exchange volatility, the relative attractiveness of investing in Japan is rising. So, what happens when one of the largest creditors to the world calls back their capital?

While we don’t yet have an answer, we are incredibly conscious of the immense liquidity drain this would bring for the global economy. The shifting economic landscape is likely to give rise to new trends and opportunities as we enter a new era for Japan and the global economy more broadly.

As we transition to this new era, we continue to follow our proven investment approach and look forward to capitalising on new opportunities to generate returns for our investors.

For investors, the current trajectory of Japan’s economy signifies a significant shift from decades of stagnation, potentially ushering in a bullish market for Japanese equities. This transformation is underpinned by a mix of Macroeconomic drivers, including GDP growth and the country’s departure from long-term deflation. While challenges such as corporate deleveraging persist, initiatives like corporate governance reform offer promise for improved shareholder returns. Additionally, identified asymmetric opportunities, such as potential policy changes and investments in specific sectors, present avenues for potential growth.

 

Understanding Japan’s “Lost Decades”

Japan’s “Lost Decades” refers to a period of economic stagnation and deflation that occurred in Japan during the 1990s and early 2000s. This term specifically refers to the period following the bursting of Japan’s asset price bubble in the early 1990s.

During this time, Japan experienced a prolonged period of slow economic growth, high unemployment rates, and deflation ― a sustained decrease in the general price level of goods and services. The banking sector was particularly affected, with many financial institutions burdened by non-performing loans and struggling to recover.

The Lost Decades had significant social and economic consequences for Japan, including reduced consumer spending, declining business investment, and increased government debt. It also led to a loss of confidence in Japan’s economic model and raised concerns about the country’s long-term economic prospects.

Efforts to stimulate economic growth during this period, such as monetary policy measures and government spending initiatives, had limited success in reversing the trend. The Lost Decades has since become a cautionary tale and a subject of study for economists and policymakers worldwide, highlighting the challenges of managing economic downturns and deflationary pressures.

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