The past year proved to be a difficult one for investors, with prices declining across regions and asset classes. While the Japanese market fell only modestly in yen terms, the reality is that under the surface, style trends were extreme: a result of aggressive action by the US Federal Reserve to address inflation, supply chain disruptions and the war in Ukraine.
On top of this, the Bank of Japan’s surprise change to its yield curve control (YCC) policy on 20 December 2022, triggered large swings in the currency, bond and equity markets. While the timing of the decision was unexpected, the objective was to improve the functioning of the Japanese government bond market.
There may be political momentum building in the background, pressuring the Bank of Japan to review its YCC policy. Bank of Japan governor Haruhiko Kuroda’s term has just ended and speculation over the future direction of monetary policy in Japan is set to intensify as Kazuo Ueda takes over.
However, concerns about a recession in the US are diminishing expectations of imminent policy normalisation under governor Ueda. Annual wage negotiations have surprised on the upside, but the central bank is likely to err on the side of caution given the heightened external risks, particularly as political hurdles to any policy change will rise markedly in the event of financial turmoil in the US.
Reacting to the macroeconomics
Inflation surprises have driven market expectations for the pace of interest rate hikes by the US Fed. As economic activity weakens, however, bond yields are likely to be restrained by lower levels of growth.
If the view that long-term rates have peaked gains traction, then this would help to put a floor under equity markets. It would also support a bottoming out in growth stocks and I would expect some of the names that performed poorly in 2022 to come back quite strongly.
The recent failure of Silicon Valley Bank (SVB) and Signature Bank and the subsequent spread of turmoil in the banking system from the US to Europe has created huge uncertainty in financial markets. Although Japanese stocks, centred on financials, have not been immune to the sell-off and compression in valuations, we do not expect any major direct impact on Japanese companies.
As to secondary effects, we believe it is reasonable to think that there could be some impact on pricing and valuations.
Given that the rise in US interest rates is losing steam, the Chinese economy is recovering, and the manufacturing cycle appears to be bottoming out, we are starting to see opportunities in early tech cyclicals. Semiconductor and factory automation related names, including MISUMI Group, Tokyo Electron and Harmonic Drive Systems, are among our key active positions.
Meanwhile, Japanese retailers and consumer product companies that have a high earnings contribution from China stand to benefit from the country’s economic reopening and an accompanying recovery in consumption.
Fast Retailing and Ryohin Keikaku, operators of the UNIQLO and MUJI brands respectively, and sportswear company Descente are key examples. Related to this, there is the prospect of a further recovery in inbound demand, including the eventual return of Chinese tourists to Japan, which will benefit urban retailers and various hospitality industries.
Under-researched companies and unlisted opportunities
Beyond these beneficiaries of shifting macro trends, we would highlight that Japan continues to offer a wealth of under-researched mid and small-cap growth companies as well as unlisted opportunities.
Global initial public offering (IPO) volumes fell sharply in 2022, with average deal sizes shrinking due to a correction in valuations and unfavourable market conditions. In an environment characterised by rising inflation, higher interest rates and persistent geopolitical tensions, investors became more cautious and the appetite for new public companies waned. The same trends prevailed in Japan.
Despite the muted market conditions that dominated 2022, we retain a high level of conviction in unlisted investments as a differentiated source of returns in Japan. The government of prime minister Fumio Kishida recently outlined a five-year plan to promote innovation and nurture start-ups, with the aim of driving a tenfold increase in the number of unicorn companies and new business launches through tax incentives, funding and government procurement.
Moreover, from our experience on the ground, we are seeing a lot more entrepreneurial activity in Japan compared with five to ten years ago.
While Japan has always been successful in automobiles and electronics, the information revolution is throwing up new opportunities in areas such as SaaS. We are also seeing new business opportunities emerge in response to major challenges facing the world, primarily climate change and decarbonisation.
Although there are concerns over a further slowdown in the global economy, the sensitivity of growth stocks to monetary policy is set to decline and the reopening of the domestic economy and the resumption of inbound demand should help to put a floor under mid/small-cap stocks.
After value stocks dominated in 2022, the relative earnings prospects of growth companies are more attractive and there is latent alpha to be capitalised upon within the mid/small-cap growth space.
Nicholas Price is portfolio manager of Fidelity Japan Trust PLC. The views expressed above should not be taken as investment advice.