Seven reasons Japanese equities are worth another look

Investor enthusiasm for Japanese equities has long been dampened by the downward trend in the market during the 1990s and 2000s, as well as by structural challenges ranging from deflation to weak corporate governance. But we think this is an opportune time to consider a Japanese equity allocation, as we see seven potential positives that seem underappreciated by the market:

1. Macroeconomics — recovering from COVID: While we’ll have to keep an eye on the Omicron variant, higher-frequency data suggests the economy has been regaining momentum since the Delta-variant-induced “state of emergency” status was lifted at the end of September. While an economic-surprise indicator for the country is currently very low, we think it has likely troughed.
2. Monetary policy — benefiting from global inflation: While many developed market countries are struggling with excessively high core inflation (particularly the US), Japan has some way to go before core inflation will require central bank tightening. In fact, reversing the “deflation mindset” would likely be a positive.
3. Fiscal policy — another massive package: The ¥55.7 trillion (US$490 billion) fiscal stimulus package announced in November will boost economic growth. Further support for small to mid-sized businesses will help aggregate consumption and business investment.
4. Fundamentals — reform and productivity: Forward return on equity in Japan has risen from low levels to around 9%. While this is below the US (27%) and Europe (10%), we think continued governance and productivity reforms should drive further improvement. Gains in the net buyback yield are also a welcome development for a market that has historically delivered less by way of shareholder return.
5. Event driven — an election boost: Historically, the MSCI Japan Index has tended to outperform the MSCI All Country World Index from 90 to 180 days after the dissolution of parliament and subsequent election (Figure 1). This has been particularly true when the new administration has begun with a narrative of credible reform with fiscal stimulus (Shinzō Abe).
6. Valuations — relatively undemanding: Even after adjusting for differences in profitability between regions, we find Japan attractive relative to other regions (the US, European Union, emerging markets). Furthermore, if we see a reflationary regime going forward, value-oriented regions could get a boost.
7. Positioning — still overlooked: Foreign flows into Japanese equities this year have been strong by historical standards — the highest since 2013, according to EPFR. But positioning data from EPFR suggests that global asset allocators were still underweight Japan by around 1.5% as of October 2021.

One final point: As our colleagues wrote recently, Japan may be an exceptional “fishing pond” for active managers, given that it is one of the most inefficient equity markets globally.

Figure 1