Japan should have been one of the hottest developed markets over recent years following initiatives from the government to stimulate growth, improve corporate earnings and look after shareholders.
In reality, the results have been less than spectacular. The Topix index of Japanese stocks has failed to beat the FTSE All Share, for example, in each of the past four calendar years, and has only beaten the MSCI World index once (in 2022) in five years.
Some analysts may point to last year’s outperformance as the long-awaited return to form for the region, but Jean Boivin, head of the BlackRock Investment Institute, is far from convinced.
The firm recently cut its position in Japan from neutral to underweight, highlighting the shifting economy and likely change in stance from the central bank as reasons to be cautious.
Inflation is starting to take root for the first time in years, which should hearten Japan’s central bank, considering it has been forced to keep rates at rock-bottom (and at times negative) levels to stimulate growth in the country.
Recent price rises are a result of two factors: a weaker yen and higher energy prices. Like elsewhere in the developed world, this has fed into wages, as the below chart shows.
Japanese wages and core CPI inflation, 1995-2023
Source: BlackRock Investment Institute, with data from Haver Analytics and Refinitiv Datastream, February 2023. Notes: The chart shows core CPI inflation, excluding food, non-alcoholic beverages and energy (Western core). The earnings line is based on the three-month moving average.
Despite the shift, however, the Bank of Japan’s (BOJ) ultra-loose monetary policy remains in place, including a cap on bond yields that requires sizable asset purchases.
“We think a policy change could come at any moment – scrapping the cap risks pushing global yields higher and reducing risk appetite,” said Boivin and his team.
“We think that paves the way for the BOJ to roll back policies that by its own measures may have achieved their goal: to foster a sustained rise in inflation toward its 2% target underpinned by wage growth.”
The central bank went further with its stimulus than many developed-world peers, but with wages on the up, this can start to be unwound.
However, the market is precarious and any halt to stimulus may stir considerable volatility. A spike in Japanese yields could cause a similar movement in other developed market bonds.
The Bank of Japan will appoint a new governor in April, but Boivin said that whoever takes charge will face an inevitable shift in policy.
How will this look?
“The Bank of Japan could widen the band on its 10-year bond yield target again – market pricing not impacted by the cap is already up to 0.5% higher than that limit. We also think the BOJ could abandon its yield curve control at any moment. That would push yields higher and stoke interest rate volatility,” Boivin said.
“It would put the BOJ on track to stop bond purchases – it owns more than half of outstanding Japanese government bonds – potentially letting its balance sheet shrink as bonds mature and pushing up policy rates.”
This could spill over to the global bond market, particularly if Japanese investors remove their considerable support for foreign bond holdings that were in place due to anaemic returns from the domestic market.
“The policy change could put the BOJ on course with a larger trend by major central banks to boost yields rather than depress them. The BOJ would then join the quantitative tightening push, with the Federal Reserve doing so now and the European Central Bank soon,” said Boivin.
All of this means BlackRock has moved underweight the market, with the potential for an economic slowdown in the country looking likely as earnings estimates decline due to fears the country’s export sector will struggle against a weaker global economy.
However, Boivin said there are “positive undercurrents of corporate reform” – a result of one of the economic initiatives in Abenomics known as the ‘third arrow’. This means there are reasons not to sell out of the region entirely.
“Japan has become a more shareholder-friendly market, in our view, with companies boosting share buybacks and dividends. We prefer unhedged Japanese equity exposures for foreign investors given the policy risks – and we also favour sectors that stand to benefit from automation, digitalisation and tourism,” he concluded.