For years, Japan was the large developed market that many investors assumed they could ignore. If the returns of the past couple of years hadn’t put an end to that, the excitement of the past two months almost certainly did.
Having tumbled to a historic low, the yen spent July and August soaring 12% against the dollar. At the same time, the equity market plunged by almost 25%, wiping out a year of gains, before rebounding by more than 20%.
On top of that, after Japan became one of the few countries in the world without an election scheduled for 2024, prime minister Fumio Kishida’s decision not to stand in his party’s leadership election this month has made that a possibility, too.
Does any of this cast doubt on the positive outlook for Japan equities, one of the most broadly held views at the start of the year?
Beyond large-caps
Let’s start with the yen. The Bank of Japan is starting to hike rates just as the US Federal Reserve is getting ready to cut them. In response, the yen has bounced hard from its recent low.
Many commentators identified this move as the origin of the carry-trade unwind that ripped through global markets in August, especially through Japanese equities and US mega-cap technology stocks.
More volatility could come as more yen-funded leveraged positions are abandoned, but many hedge funds had been short Japan in anticipation of this carry-trade reversal. Also, the scale of the market rebound suggests that many of those positions were covered and we may have seen the worst.
Even so, further appreciation of the yen would have fundamental and technical implications for equities. In our view, one of the reasons Japanese large-caps have been performing so strongly is that these companies benefit directly from a weak yen by generating, by our estimate, some 60% of their revenues and 70% of their profits from overseas, in dollars.
Look beyond large-caps, however, and the story is very different. We estimate that Japan’s small- and mid-caps generate, on average, only 30% of their revenues abroad.
Moreover, many could even benefit from a stronger yen, as that would release funds for domestic consumption by reducing the cost of imported energy and goods.
This decline in consumer costs would be happening just as the government is pressuring employers to support real wage growth, which turned positive in July for the first time in two years. We think household spending is set for a sustained recovery after declining for much of the past 18 months.
We note that Japan’s Consumer Confidence Index has been climbing faster than economists’ expectations recently and that private consumption, which had been falling for a year, was a major driver of Japan’s strong second-quarter GDP growth.
These domestic consumption trends are likely to feed straight into Japanese small- and mid-cap companies’ top lines.
Rising rates and the rebound in yen are part of the necessary growing pains of an economy normalising after decades of stagnation and deflation. There will be volatility, but the trajectory is positive.
Shareholder value
How about the strong market rebound? Was that all just technical short-covering before another dip lower, or did it also reflect long-term investors buying on fundamentals?
We think investors appreciate the resilient fundamentals. Larger companies may miss an excessively weak yen, but they still reported robust second-quarter earnings and gave mainly positive guidance.
So valuations are lower now than they were in July, not just market prices. And with the yen apparently bottomed out, they look even more attractive to dollar, sterling or euro investors.
The longer-term trend toward focusing more on shareholder value remains in place, too, in our view. That is already translating into higher dividends, more share buybacks and stronger balance sheets.
We anticipate more of that as cross-shareholdings between public companies continue to be dissolved and company boardrooms are shaken up: June’s slate of annual general meetings saw further declines in support for director nominees at companies with governance issues.
That governance alignment is happening in response to growing shareholder activism, but also to keep the activists at bay. The number of shareholder proposals companies received during 2022, 2023 and 2024 was around double the norm in previous years, according to figures from Glass Lewis.
Household names in private equity, such as Bain, Carlyle and KKR, are setting up or expanding their Japan operations and launching dedicated funds, triggering a wave of management buyouts and takeover bids, often at meaningful premia to market prices.
We believe this growth of shareholder activism and M&A activity adds further support for small- and midcaps. These firms have lagged Japan’s larger, more internationally held companies on corporate governance, but outside pressure is now beginning to concentrate minds on boosting return on equity.
Between the market trough in October 2022 and the eve of this August’s sell-off, the MSCI Japan SMID Cap Index underperformed the MSCI Japan Large Cap Index by close to 25 percentage points. We think a sustained yen reversal combined with meaningful governance reform could go a long way to close that gap.
Active managers and engaged owners
Finally, how important might Kishida’s resignation be? He has been a market-friendly prime minister, building on the reforms of the late Shinzo Abe and Junichiro Koizumi, but his approval ratings of around 20% in several recent opinion polls had become unsustainably low and his resignation was therefore not a big surprise.
If the new Liberal Democratic party leader can command approval above 50%, the probability of Lower House elections in 2024 will rise. This might require a more populist pitch to the electorate, but all the leading candidates are in the economic mainstream of the party and, in any case, at the moment some consumer-friendly subsidies would be more likely to support than harm Japan’s economy.
In short, events in Japan over recent weeks have not changed the country’s fundamental investment story, in our view. They have merely made it slightly cheaper.
For active managers and engaged owners in Japan’s under-researched small- and mid-cap universe, in particular, we believe the long-term outlook will turn out to be even more exciting than the rollercoaster ride of August.
Keita Kubota and Kei Okamura are portfolio managers at Neuberger Berman. The views expressed above should not be taken as investment advice.