Calm after the storm for Japanese stocks?

Japan’s equity markets have seen extreme turbulence lately, with the Nikkei experiencing its worst one-day drop since 1987 in the first week of August. While market volatility may continue in the near term, Nicholas Price, portfolio manager of the Japan Trust believes that fundamentals and valuations will return to the fore once the selloff has run its course. As a multi-decade investor in Japan, he reflects on the recent challenges facing investors and analyses how he believes the market environment is likely to evolve over the coming months. 

Japanese stocks corrected by more than 20% from their peak on July 11, with key indices suffering historic losses on August 5. There were several factors behind this sharp downturn, namely rising concerns about a recession in the US, unexpected hawkishness from Bank of Japan (BoJ) Governor Ueda and accelerating Yen strength leading to an unwinding of the carry trade. 

Volatile markets 

In the near term, markets are likely to remain volatile, though the absence of any material shift in domestic fundamentals suggests that the Japanese market will remain susceptible to concerns over the US. However, once the selling has run its course, fundamentals and valuations will come back into focus. Indeed, the recent FY24 Q1 reporting season in Japan delivered positive results and record levels of share buybacks, and the current forward price-to-earnings ratio of 14x is below the recent historical average. Moreover, we believe that Japan’s economic shift to moderate inflation and its impact on spending and investment decisions by households and corporates, combined with steady progress in governance reforms, represent multi-year structural trends that are supportive of Japanese stocks over the longer term. 

Brighter outlook for small and mid caps 

Excessive recession fears in the U.S. and short-term adjustments in positions in response to the BoJ’s interest rate hike have led to a rapid appreciation of the Yen and a sharp decline in stock prices. However, we have not seen a material change in corporate fundamentals and I believe that this is a short-term unwinding of positions that has gone too far. 

As the Fed moves closer to interest rate cuts in the US, the outlook for Japanese mid/small caps should start to improve. From a valuation perspective, Japanese mid-caps are trading at a steep price-to-book discount to larger cap indices and have lost all the price-earnings premium that was a constant feature of the past decade or so.  

Some semiconductor-related and mid/small-cap growth stocks have become oversold, and I have been selectively buying at the margin, while reconfirming fundamentals with our analysts. The likelihood of additional rate hikes by the BoJ has diminished, so I have slightly reduced positions in bank stocks. 

The more hawkish BoJ stance that accompanied the recent rate hike is also likely to reinforce the change in trend on the currency toward Yen strength with the partial reverse of the Yen carry trade. This may also benefit more domestically oriented companies of which many are mid-caps, where the portfolio is overweight versus the index. 

I am also encouraged by a broadening out of the Tokyo Stock Exchange  reforms and expect to see a clear improvement in capital efficiency and shareholder returns (a trend that was initially led by large-cap value companies) further down the market-cap scale. 

At the same time, I am finding opportunities in typical large-cap sectors where companies are moving from value to growth, and signs of improvement in the global manufacturing cycle are supportive of technology and factory automation stocks that have struggled in recent years. 

The uncertainty in the market is allowing us to invest in strong growth companies at very attractive valuations. Japan’s shift to moderate inflation, combined with broadening corporate governance reforms, are supportive of the mid-to-long-term outlook for the Japanese stock market, where we remain positive on growth stocks.