How Much Higher Can Japanese Stocks Go?

Elizaveta Gridneva of IBKR Hong Kong welcomes Nick Ng back to the IBKR podcast to discuss all things Japanese markets. From rising bond yields and yen intervention to Japan’s equity rally, corporate governance reforms, and the forces shaping its long-term outlook, Nick breaks down what investors should be watching.

Summary – IBKR Podcasts Ep. 428

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Elizaveta Gridneva

Hello, everyone. Welcome to Interactive Brokers Podcastå. My name is Elizaveta Gridneva. Today I’m joined by Nicholas Ng, who is Head of Asia Pacific Wealth Business at Daiwa Asset Management. 

Listeners who are already with us, you know Nick. So hi, Nick. Welcome back. 

Nick Ng

Hi, Elisa. Thank you for having me back on the podcast. 

Elizaveta Gridneva

Thank you. We are very curious to hear your updates on Japan, so let’s dive straight into it. Japan’s cabinet approved Prime Minister Takeichi Sanae’s first major growth strategy in June. How is this expected to impact the overall Japanese economy? 

Nick Ng

So the Takeuchi administration announced their first major fiscal stimulus package of around 370 trillion Japanese yen, which is equivalent to about 2.3 billion US dollars. And this is expected to be focused or spent on 17 strategic sectors, primarily being the AI sector, semiconductors and chips, as well as clean energy and healthcare. So there’s around 25% of the spending going to be focused on the AI sector. And from our perspective, if there was no fiscal growth package, it’s likely that GDP for Japan up until the year 2040 could be around 0.5%, which is fairly flat. However, if the effects of all the investments as well as capital allocation are fully realized and actually materialized, GDP for Japan up until the year 2040 could potentially hit 1.8%. 

Elizaveta Gridneva

That’s great. And also, we see 10-year Japanese government bond yields hit 3% this week. What are the recent drivers for higher yields? 

Nick Ng

So JGB yields have been trending higher over the last couple of years and have really started to accelerate in the last few weeks. And this is for a few reasons. The first reason, following on from your first question, Elisa, is that the Japanese government is expected to spend a lot more. And if the government is expected to spend more, this means that they would likely need to issue bonds to raise the fresh capital. And as they issue more bonds, bond prices go down and yields tend to rise higher. So that’s the first one. 

The second one is essentially inflation in the US has started to pick up, and as inflation is higher, this means that interest rates in the US could potentially be hiked. And as US Treasury yields tend to go higher, this also pulls up global yields, and Japan is no exception. So Japanese JGB yields have also been increasing. 

And the third reason is the Bank of Japan, which is the central bank of Japan, is likely to hike interest rates earlier than the market expected. So if we break down this third point, the Bank of Japan focuses on two main economic indicators. The first indicator is inflation in Japan, and inflation in Japan has been steadily bouncing back, and the last reading was at 1.9%, which is very close to the BOJ’s target. 

The second economic indicator which the Bank of Japan looks at is real wage growth. And real wage growth, the last reading was 1.6%, which, for Japan’s case, is fairly positive because for the first half of this year, real wage growth in Japan has been in positive territory, which is one of the longest winning streaks of real wage growth in Japan since 2001. So originally, the market did expect the Bank of Japan to hike interest rates by 25 basis points in December this year. But given that inflation and real wage growth have been fairly strong, it’s highly likely that the Bank of Japan will hike by 25 basis points this month, being September. 

Elizaveta Gridneva

Thank you, Nick, for such a detailed 360 view on the questions, and I think it really helps us to understand better what’s happening. 

And now moving on to something that was in the headlines recently. There’s been a lot of noise in the Forex markets with the US intervening to help support the Japanese yen. Could you please share some color on what’s going on there? 

Nick Ng

Sure. So the Japanese yen has been trending lower over the last couple of months, if not couple of quarters, and it was as weak as USD to JPY 164. And the reason, following on from your earlier questions, is the amount of spending that the Japanese government may need to do in order to push for this fiscal stimulus package. Essentially, as the government spends more, the fiscal health of the Japanese government becomes worse, hence why, in this case, the Japanese yen is weakening. Now, I’m sure most market participants do understand this, and there are a couple of ways that Japan is able to combat the yen weakness. 

So the first option which Japan is able to do is they could potentially improve the fiscal health of Japan. But in order to do that, the government would need to spend less and tax consumers and businesses more, which in this case is unlikely given they’re doing the opposite to stimulate the economy. 

The second option could be to potentially ask pension funds such as GPIF, which is one of Japan’s largest pension funds, to repatriate money back to Japan, meaning that pension funds would potentially sell overseas stocks and bonds and use that cash to bring it back to Japan and buy domestic stocks and bonds, hence supporting the Japanese yen. 

The third option could be for the Bank of Japan, which is the central bank, to hike interest rates faster than the market expects. And in this case, it does seem like it’s about to happen, given that inflation and real wages have started to pick up. 

And the fourth option is probably the most controversial, which is to intervene in the FX market. What’s essentially happened recently is, previously, Japan would intervene in the FX market themselves by buying their own Japanese yen. But recently, the US has also come in to intervene and also buy Japanese yen. 

Now, when Japan needs to intervene and prop up the Japanese yen, they essentially need to sell US Treasuries to raise cash to do so. And Japan is one of the largest holders of US Treasuries. So if Japan does sell US Treasury bonds, this means theoretically that the yields in the US will trend higher, which is obviously not what the US wants. The US is trying to lower Treasury yields. 

So what it appears has happened is Japan and the US have come to some sort of “you help me, I help you” type of arrangement, where Japan says, “We need to prop up and support our Japanese yen, but in order to do so, we need to sell US Treasuries.”  And so the US has also come in and most likely said, “Well, we ideally wouldn’t like you to sell US Treasuries, so we’re gonna have to come in and support and buy the Japanese yen.” And the US has sold euros in order to do so. 

So it’s almost like creating some sort of political-type win-win situation where Japan is able to support its yen and the US doesn’t have a huge rise in US Treasury yields. Now, something quite interesting that’s happened recently is, a few months ago, the market for speculators and hedge funds were record short the Japanese yen. So if we look at the CFTC, CME, Japanese yen net non-futures commercial positioning, everybody was record short the Japanese yen, and it was almost at its record level, which is essentially an incredibly crowded trade. 

Now, what’s happened is after the US has started to intervene, the magnitude of the intervention has been a lot higher than the market expected. So the move was from 163 up until around 157. And this has obviously scared off a lot of hedge funds and speculators who have shorted the Japanese yen. So going forward, it does appear that the market now knows the US is also able to intervene and the magnitude of the move there can be fairly large, which generally signals that, at least in the short term, the Japanese yen is likely to range trade. 

Elizaveta Gridneva

That’s great. Thank you, Nick. That’s very interesting to know, and quite an exciting chain of events is happening. And moving on to equity markets now, can you tell us what the latest trends are within the Japanese stock market? 

Nick Ng

Sure. So this year has been a little bit different to previous years. In previous years, Japan has been very much a dominant value market, meaning value stocks, so companies with low valuations, tend to outperform growth stocks, so companies with high earnings growth. Only up until this year, the difference between the performance in value stocks and growth stocks has been fairly even at a style level. Of course, companies within every sector outperform and underperform, but it’s quite interesting to see that growth stocks have been able to perform in line with value stocks in general this year. 

And you can probably notice that the reason why growth stocks have been performing fairly well is because of US AI and chip-related names, which have been really driving and pulling up Japanese-related AI and chip names, as well as broader tech names such as Kioxia or SoftBank. And this is why the Nikkei 225 Index has performed very well since the start of the year. Now, if we flip this over and look at the other side for value stocks, value stocks have been fairly resilient and very stable this year, with a steady grind higher. And we think it’s likely driven by a few reasons. 

The first reason is the Financial Services Agency, or FSA, which is a regulator. They had a draft revision to their corporate governance codes back in April. And they did say that companies who have low valuations or who are not using shareholder money efficiently, they not only want these companies to buy back shares or pay higher dividends, they would also like these types of companies to start investing into growth and also focusing on business growth. 

The second reason is it’s now getting a little bit easier to replace the CEO of a company in Japan. And the reason why this is quite interesting is, given Japan has been in deflation for close to three years, the mindset of corporate management teams and CEOs has essentially become incredibly risk-averse. So a lot of corporate management teams and CEOs may be resistant to change, and they may not want to improve their companies or do anything like that. So being able to replace a CEO does stimulate or motivate the existing management teams to do what’s best for shareholders. 

The third change, or support for value stocks, is a fairly recent one where if a company is within the bottom 3% of a TOPIX Index, they could potentially be removed from that TOPIX Index if they don’t improve their market cap or equity value. 

So I think these are the main trends that we are seeing within the equity market this year. 

Elizaveta Gridneva

Great. That’s very interesting. And let’s just kind of look at what’s there in the future. So how much upside could there still be for Japanese stocks, and what should investors look out for? 

Nick Ng

So currently, the TOPIX Index is trading at 4,100 points, and we believe, or we forecast, by the end of the year that the TOPIX Index could potentially hit 4,400 points. Given that we do sit in Asia, we’ve been very fortunate to speak with a range of investors and many investors this year on their views on Japan. And we get a lot of questions from investors asking us along the lines of, “How much more upside is there in Japan? Should I buy on weakness? Is this a bubble? When should I buy?” And a lot of questions like that. 

And I think for investors who aren’t familiar with Japan or are considering investing into Japan, probably the easiest way to think about this is there are two engines powering the upside in the Japanese stock market. 

So the first engine is inflation. As inflation rises, the economy tends to improve, and also real wage growth tends to improve as well because individuals are able to spend more and have more spending power. As individuals are able to buy more goods and services, corporate profits also rise, and this creates a positive feedback loop where, you know, this is really driven from the economic side. 

The second engine which investors should consider or think about is the two unique drivers which are powering the Japanese stock market. 

So the first one is the Nippon Individual Savings Account, which is known as NISA for short. Essentially, we estimate there’s over $7 trillion US sitting in consumer deposits or household cash, which is slowly trickling into the Japanese stock market as one major driver. 

And the second one is corporate governance reforms. So we estimate there’s a bit over $1 trillion US of cash sitting on corporate balance sheets in Japan today, and this money is slowly trickling into the stock market as well through share buybacks. 

Another question that we get is, you know, how much longer can this bull market be sustained for? And I think the best way to think about this is between a structural investment theme versus a cyclical investment theme. So structural investment themes, they tend to be incredibly long-term, and they would continue across multiple business cycles. And I guess the primary driver is internal government regulations, which is really pushing this theme. And when we think about it from an asset price behavior perspective, investors should think about this as a long, drawn-out S-curve, which is essentially a very long grind higher. 

This is very different from cyclical types of investment themes, where the rise and fall of cyclical themes tends to be in line with a business or economic cycle. And in terms of, I guess, asset price behavior, these tend to be FOMO retail-driven, where there’s a really strong narrative. And in terms of the asset price behavior, there tends to be high valuations versus cash flow and a significant or elevated amount of volatility. So for investors who are thinking about Japan, try to think of Japan as having two engines powering the stock market. And we do think it’s worth thinking about Japan as a long-term structural investment theme, not a shorter-term cyclical fad. 

Elizaveta Gridneva

Thank you, Nick, for your analysis and for insights on Japan, as always. Great to see you today. 

Nick Ng

Thank you very much for having me back, Eliza. 

Elizaveta Gridneva

Thank you, everyone, for joining us today, and subscribe to IBKR Podcast from whatever platform you are listening from. Thank you!