The stellar rise of the Nikkei Index

Something remarkable has been happening in Japan — their local stocks are riding a powerful wave that's propelling the Nikkei 225 index (also known as Japan 225) to heights reminiscent of its golden era in the late 1980s. 

The BlackRock Investment Institute, a research arm of the global financial giant, has recently adjusted its outlook on Japanese equities from negative to neutral. This move is seen as a pivotal moment in the Nikkei's resurgence, possibly attracting more well-capitalised investors to join the upward momentum.

Nomura Securities, Japan's largest brokerage firm, foresees a ripple effect. They estimate that around 10 trillion yen (equivalent to 70 billion USD) could pour into the Japanese market as foreign long-only investors rebalance their portfolios to reach neutral allocations.

A significant driving force behind this influx of foreign investment into Japan can be traced back to billionaire investor Warren Buffett, who first made headlines for his investments in Japanese stocks as early as 2020. Subsequent inflows were largely driven by fast-moving algorithmic traders and hedge funds utilising borrowed funds. Then, a notable shift occurred, with a substantial amount of enduring investment making its way into Japan.

Archie Ciganer, a portfolio manager at T. Rowe Price, highlighted how their firm has been fielding inquiries about Japan investments from clients and regions that hadn't shown previous interest. This shift has been attributed to a growing number of asset owners opting to steer clear of China’s slower-than-expected recovery, effectively propelling Japan to the forefront in Asia.

The Nikkei even achieved a remarkable 33-year high of 33,772.89 on June 19, 2023. Although there was a brief pullback toward the end of the month due to short-term investors cashing in profits, there was a minor reversal in late June with a net sale of 543.8 billion yen. Many experts argue that these declines are a healthy retracement before the market's next upward surge.

A few fundamental factors are fuelling Nikkei's remarkable resurgence.

Robust economic growth

Japan's economy has defied recessionary expectations, displaying robust GDP figures in the first half of 2023, particularly in the second quarter when it grew at an annualised rate of 6%. This isn't just Japan's best GDP performance since the mid-1990s; it's also one of the top growth rates among all major world economies.

Trade account surplus

In July 2023, Japan's current account surplus increased more than threefold compared to the previous year, reaching 2.77 trillion yen (19 billion USD). This marks the sixth consecutive month of positive current account balances in 2023. These positive trends suggest a strong trade balance, a revival in inbound tourism, and healthy investment income, which may also be influenced by the lower value of the yen.

Deflation to inflation

A moderate level of inflation is beneficial and indicates a growing economy. Japan is making progress in moving away from its long struggle with deflation, and there are encouraging signs of economic growth, such as meeting the 2% inflation target. One example is that consumer prices in Japan, excluding fresh food, have remained positive this year. This is a positive sign for stock market valuations, making them more attractive.

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Corporate reforms and shareholder engagement

Investor optimism in Japanese stocks is partly due to the specific requirements set by the Tokyo Stock Exchange. They recently established new market restructuring rules, which challenge companies with low price-to-book ratios to improve their profitability and boost their share prices.

In response to these rules, many businesses have initiated reforms, leading to significant share buybacks and increased engagement with shareholders. Activist shareholders are also putting pressure on Japanese companies to improve their operations and uncover hidden value. Efforts to address issues like low return on equity (ROE) and operating margins are in full swing. As companies implement restructuring and cost-cutting strategies, it makes the long-term investment case for Japanese stocks more attractive.

Supportive monetary policy

In the last 2 years, global inflation has been exacerbated by the Ukraine crisis. Meanwhile, Japan is finally able to counter its long-standing battle with deflation and is very likely to continue keeping to its 2% inflation target in the near future. The inflow of imported inflation, an improving capital expenditure environment, and a tightening labour market are additional factors contributing to Japan's transition away from a deflationary era, which, in simple terms, means positive signs for economic growth.

A pivotal aspect of Nikkei’s resurgence is the Bank of Japan's (BOJ) tweak in yield curve controls. The BOJ has finally increased the cap on its 10-year yields from 0.5% to 1%. This signals that Japan is gradually becoming more flexible in its monetary policy, potentially enhancing the credibility of Japan's financial markets. Typically, a flatter yield curve signifies caution about a country's growth prospects, while the rise in long-term yields generally indicates that Japan's economy is moving toward further growth.

Impact on stock valuations

In a September 2023 interview, Bloomberg reported that a member of the BOJ's policy board, Hajime Takata, mentioned that it's highly unlikely for Japan to raise interest rates, as ultra-low rates are essential for sustaining healthy economic growth. These low rates encourage investors to seek better returns in the stock market, driving up demand for Japanese stocks. 

Additionally, the contrast between Japan's low rates and increasing rates in other parts of the world would likely result in a significant weakening of the yen. A weaker yen, in turn, makes stocks more affordable for investors, further contributing to higher stock prices and increased stock valuations in Japan.

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In summary, taking into consideration all of the factors and opinions mentioned above, Japan’s stellar rise to ascent to the forefront of Asian equities is not a mere coincidence but a result of multiple forces converging in a propitious manner. The shifting sentiments of foreign funds, bolstered by corporate reforms, economic growth, and policy adjustments, have propelled the Nikkei on a trajectory toward its historic peak. The second half of the year promises further excitement, with any market pullback being interpreted as a buying opportunity by astute investors. As the stars align for Japan's equity market, it appears that it's time for Japan to step out of its long-term valuation depression and trade at a premium once again.