Since Tokyo’s Nikkei 225 index peaked at 39,000 in 1990, investors have been well served by avoiding the Japanese stock market. Although it rallied strongly in 2016 and 2017, the benchmark is still down almost 50% from its highs making it the worst-performing major index by a wide margin.

However, with the Nikkei now trading at just over 20,000 points, half its level of nearly 30 years ago, and the economy growing at its best rate in decades, we think it’s time for investors to take another look at Japan.

FROM BOOM TO BUST

In the late 1980s, when much of the West was seen as in decline, Japan experienced an enormous bubble in domestic real estate and share prices.

Ultra-low interest rates and government stimulus sent property prices through the roof. Valuations became so detached from reality that by 1989 the grounds of the Emperor’s palace in Tokyo were said to be worth more than the entire state of California.

At the same time Japanese banks became the biggest in the world by market value and the chief executives of major corporations competed for trophy assets like New York office buildings, fine art and classic cars.

Even dull, run of the mill stocks were chased up to 50 to 100 times earnings, helped by Japanese companies using the cash on their balance sheets or gearing themselves up to play the market, a practice known as ‘zaitech’ which gave business leaders great bragging rights.

In late 1989 a new governor took over the Ministry of Finance with a mission to crack down on speculation. The stock and property markets continued to climb into 1990 but finally they cracked in spectacular style.

The deflationary bust that followed the market collapse saw economic growth turn negative along with wage growth and consumer spending and Japan went into what became known as the ‘Lost Decade’.

Bad loans grew at such a rate that the government had to bail out many of the smaller banks, which became known as ‘zombies’ because they could neither lend nor borrow but were just kept from failing.

Productivity stagnated, consumers saved their money rather than spending so domestic demand collapsed, and finally inflation turned into deflation.

EXTRAORDINARY TIMES CALLED FOR EXTRAORDINARY MEASURES

With core inflation turning negative, in February 1999 the Bank of Japan introduced a zero interest rate policy to try to stimulate the economy and dispel fears of deflation.

By the summer of 2000 prices seemed to have turned back up and the central bank called an end to zero rates, but it was premature and six months later had to reverse course again.

As well as zero rates, the bank experimented with quantitative easing (QE) by pumping money into the financial system and buying government bonds, a policy which it carried on until 2006 when inflation turned positive.

Unfortunately the bank exited QE just as the world was about to enter the great financial crisis which sent inflation and the economy into another downward spiral.

GROWTH HAS RECOVERED THIS DECADE

The election of current prime minister Shinzo Abe in 2012 brought much-needed change on an economic and a political level.

As well as introducing a three-pronged approach to revitalise the economy, dubbed ‘Abenomics’, the new prime minister brought political stability: before Abe’s election there had been six prime ministers in six years.

With the economy improving and a shortage of workers due to Japan’s well-documented declining population, wages began to rise which fed through into higher consumer confidence and higher spending.

Christian Keller, head of economic research at Barclays, notes that Japan’s economy is experiencing its longest post-war expansion this decade.

‘Contrary to widespread perception, per-capita GDP growth since the great financial crisis has actually been stronger in Japan than in the US, the Euro area, the UK or Canada,’ he adds.

The tight labour market has lifted salaries for low-paid workers which means that the gap between the highest-paid and the lowest-paid has narrowed, improving social equality.

Meanwhile more women have entered the workforce, and salaries are rising: from this April, all Japanese companies are required by law to pay women and men the same salary for the same job, which will help reduce the ‘gender gap’.

Inflation, while some way short of the government’s official target of 2%, is rising and the threat of deflation looks to have been defeated.

ECONOMIC FORECASTS ROBUST DESPITE GLOBAL SLOWDOWN

In its latest World Economic Outlook the International Monetary Fund cut its forecast for global growth this year from 3.7% to 3.3%, the slowest rate of increase since 2009.

The best growth is seen in ‘emerging’ economies, including China, which make up close to 60% of global GDP and are expected to grow by 5%, while ‘advanced’ economies including Japan make up the other 40% and are seen growing by less than 2%.

However, while the US and the Euro area are seen slowing this year – US growth from 2.9% last year to 2.3% and the Euro area from 1.8% to 1.3% – growth in Japan is seen accelerating from 0.8% to 1%.

There are risks to these forecasts from an escalation of the trade war between the US and China, currently huffing and puffing like a pair of sumo wrestlers, but the implications for Japan are positive.

Moreover Donald Trump’s decision to abandon the Trans-Pacific Partnership has been good news for Japanese companies who have been able to increase their share of regional trade without having to compete with US firms.

There are also structural changes afoot within Japan which could cushion its economy and its stock market to a degree should a trade war develop.

DEMOGRAPHICS COULD BE A BLESSING AS WELL AS A CURSE

Japan’s shrinking population is driving structural and technological changes which may offer clues for Europe as it confronts its own demographic problems in the next couple of decades.

As the shortage of people entering the workforce led to higher wages, Japanese companies have looked for ways to improve their productivity: if they can’t hire more workers, they need their existing workers to be more productive.

With company earnings at high levels, more money is being invested in software and services not to replace workers but to help them do their jobs faster and better.

Eiji Saito, Tokyo-based manager of investment trust JPMorgan Japan Smaller Companies (JPS), is a firm believer that the technology sector is set to be a big winner.

‘We are overweight technology, especially companies serving the financial industry. That means that we can be underweight traditional financial stocks like regional banks,’ says the manager.

The terms overweight and underweight are used by fund managers to indicate their preference for stocks or markets relative to particular indices or benchmarks.

For Saito, the issue of demographics is also a reason to be underweight real estate, consumer staples and consumer discretionary stocks.

CORPORATE GOVERNANCE IS IMPROVING

One of the biggest issues foreign investors have had with Japanese companies is their poor corporate governance compared with international standards.

For Lucy Macdonald, who heads the global equities team at Allianz Global Investors, the list of companies which meet the desired governance criteria is so small that ‘either everyone ends up owning the same stocks or they are priced out’.

However the Corporate Governance Code, which was introduced in 2015 and updated last year, seems to be making a difference.

A major target of the code is ‘keiretsu’ or the decades-old practice of cross shareholdings built up to defend the interests of groups of companies. The 2018 revision to the code explicitly states that companies should have a policy for reducing cross shareholdings.

Other targets include freeing up cash on the balance sheet to increase shareholder returns, for example through increased dividends or share buybacks.

In February this year, Japan Tobacco, Softbank, Sony and Yamaha Motor all surprised investors by announcing they would buy back their own shares in response for calls for higher returns.

Joe Bauernfreund, lead manager of investment trust AVI Japan Opportunity (AJOT), says: ‘Activism or shareholder engagement is no longer a rarity in Japan. Attitudes have shifted dramatically since the taboo days of 2005 when activists’ arguments were seen as myopic. Companies today are open to suggestions and in some cases welcome them.’

RISKS VERSUS REWARDS

As well as the risk of an escalation of trade wars, Japan’s economy is saddled with a high level of government debt from the various rounds of QE used to stimulate the economy.

According to the OECD, at the end of last year Japan’s government debt was equal to 238% of GDP, the highest ratio of any G20 country and more than double those of its major trading partners like the US (104%), China (50%) or Germany (60%).

The government is raising VAT by 2% this autumn in an attempt to increase its income but in order to head off a drop in consumer spending – as happened when the last hike was introduced in 2014 – it has had to launch various spending packages to help households.

There is also political risk. Despite the fact that Shinzo Abe was re-elected as prime minister, there is a risk that he becomes a victim of the backlash against the Liberal Democratic Party which has been embroiled in a number of public scandals.

Finally, the yen itself contains risk. Considered a ‘safe-haven’ currency by global investors, it tends to rally when volatility and nervousness increase. This has the effect of depressing Japanese stocks because a strong yen makes exports less attractive.

However, given the potential for Japanese companies – especially those plugged into the structural changes taking place in the domestic economy – to grow their earnings sustainably over the next five to 10 years this looks like a market to buy sooner rather than later.

RISING DEMAND FOR JAPANESE STOCKS

Data from Japan’s stock exchanges shows that foreign investors turned net buyers of Japanese stocks since the start of April.

Overseas investors bought a net ¥800bn ($7.2bn) of stocks and futures in the first week of this month, their biggest weekly net purchase since last September.

WHAT IS ABENOMICS?

Abenomics refers to a set of aggressive fiscal and monetary policies and structural reforms designed to pull Japan out of its decades-long deflationary slump.

Fiscal stimulus began in 2013 with a ¥20trn ($210bn) package of which ¥10.3trn ($116bn) was direct government spending on big infrastructure projects like earthquake-resistant bridges, tunnels and roads. Another ¥5.5trn boost followed in April 2014, and after the December 2014 elections Abe pushed through another spending package worth ¥3.5trn.

The Bank of Japan’s unorthodox quantitative easing policy, which dates back to the early 2000s, is central to Abenomics. The Wall Street Journal called it ‘a gigantic experiment’ yet the Federal Reserve and the European Central Bank later adopted the same policies to support their own economies in the aftermath of the financial crisis.

Structural reforms of Japan’s economy were long overdue. Changes included slashing business regulations, opening up the labour market and the agricultural sector, cutting corporate taxes, and increasing workforce diversity. The reforms were aimed at rejuvenating the economy but also at reviving Japan’s competitiveness internationally.

THREE FUNDS TO BUY FOR EXPOSURE TO JAPAN

Investment fund Baillie Gifford Japanese (0601113) invests in ‘quality growth’ companies with a highly concentrated portfolio of holdings and has achieved 13.55% annualised returns over the past decade.

Man GLG Japan Core Alpha (B0119B5), another fund, looks for unloved ‘value’ stocks. It has achieved 9.81% annualised returns over the past 10 years.

Investors simply looking for a low-cost way to get exposure to the market should snap up exchange-traded fund Vanguard FTSE Japan ETF (VJPN) which tracks the performance of large and mid-cap companies in Japan including Toyota and SoftBank. Launched in 2013, it has achieved 12.08% annualised returns over the past five years.

****UPDATE 25 APRIL 2019*****

Please note that trading in Japanese funds is likely to be disrupted until 6 May as the country’s stock market is closed for a 10-day national holiday. Many funds investing in the country may suspend dealing during this period.

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