Time to shine: A compelling case for Japanese equities

After three decades in the shadows of more dynamic equity markets globally, Japan’s recent economic rebound has turned domestic companies into a longer-term, strategic allocation opportunity.

Japan’s resurgence as an investment destination of choice, amid behavioral changes by consumers and companies alike, offers renewed scope for the domestic equities market to flourish over the longer term.

The country’s revival and the market’s corresponding performance have been well-documented throughout 2023. The trigger has been the confluence of supportive macro, fundamental and market dynamics, with company-specific competitive advantages enabling Japan to gain increasing traction in many global portfolios after a three-decade lull.

More specifically, equity investors are embracing the return of inflation in Japan. Rather than the dampening effect this typically creates in developed markets by challenging corporate margins and increasing living costs, it is positive in an economy like Japan, which has suffered from deflation for so many years. Notably, Japanese companies can finally raise prices and potentially boost margins after many years of forced cost discipline. Further, local savers should now be more willing to invest in assets such as equities to maintain purchasing power.

Coupled with policies to improve corporate governance and profitability, positive sentiment has sparked the domestic market into life again – the Topix surged over 25%¹ in yen terms in the nine months to September 30 2023. By contrast, the MSCI World Index gained around 12%, in USD terms, during the same period.

This momentum looks set to continue. Such optimism rests on the return of moderate inflation, government support, corporate reforms, and competitive edges in sectors likely to ride on the wave of key megaforces such as digital disruption and artificial intelligence (AI).

In turn, the public equities of Japanese companies of all sizes create a compelling picture for global investors.

Riding a resilient equities wave

Japan’s economic recovery is a fundamental factor positioning equities for sustained growth.

Corporate reforms are key to shaping this trajectory. More specifically, targeted efforts over the past decade have resulted in stronger, better run, and more profitable domestic companies. The upshot is the potential to unlock some of the significant value embedded in Japanese corporates. In particular, there are competitive advantages within the country in the key global trends of technological innovation and aging populations.

Diversification is another driver for global portfolios to allocate to Japanese equities over the longer term.

This is based on two factors; not only can macro conditions in Japan offer a different type of exposure, but the sector composition of Japan’s stock market is well-diversified compared with other developed markets. For example, rather than being dominated by a handful of tech stocks, as in the US stock market, or by the semiconductors as in Korea and Taiwan, Japan provides access to a range of industries, along with low correlations to other asset classes. For global investors, all this translates to portfolio resilience.

Further, the combination of strong earnings momentum in Japanese equities – without them being overvalued – should support key sectors in Japan over time. Plus, the yen is historically low. Yen depreciation has been a tailwind for Japanese equities while diminishing returns for overseas investors (investing in other currencies). If the yen is to reverse the course from the 30+ years low here, this would hurt exporting companies, however, there is a lot more than currency impact in earnings growth, and overseas investors should benefit from currency effect.

Japan, U.S. and Europe return on equity

Diffusing the doubters

Inevitably, some investors who have seen the rapid rise in Japan’s recent fortunes, with equities soaring, are questioning the strength and longevity of these foundations. Yet this scepticism reflects myth more than it does reality.

Among the common points to clarify:

• Timing: “It’s too late to enter the market” – While the Topix has performed strongly in 2023, Japanese equities shouldn’t be seen as a tactical play based on a short-term view. The key is to get exposure over the longer term, in line with the market’s structural growth story. Being nimble as new opportunities arise is an effective source of outperformance and superior risk-adjusted returns in Japanese equities, highlighting the importance of taking a flexible approach.

• Valuations: “It’s too expensive now” – This is a short-term perspective, given that the factors which lead to outperformance in Japan can change. This creates multiple ways for investors to generate alpha over time, especially as different pockets of the economy recover at different times. Plus, despite recent outperformance, Japanese equities are not expensive, relative to their own history, and to US equities.
• Policy: “It’s no different now than during the era of Abenomics” – The economy today doesn't compare with a decade ago. Firstly, wage hikes have triggered demand-led inflation and enabled quality companies to increase prices and, therefore, margins. Secondly, geopolitical shifts that have caused semiconductor-related companies to rethink supply chain have reinforced Japan's technology capabilities – with subsequent inbound investments plus government subsidies expected to spur further innovation and sustain growth. Finally, meaningful corporate reforms have materialized, with restructuring leading to more growth-oriented businesses over the long term.

Making active choices in Japan

As with many markets, active investing is critical to achieving consistent outperformance in Japanese equities.

The economic shifts playing out in Japan align with many disruptive forces reshaping the world around. These changes create opportunities for investors to capture upside across themes from electric vehicles, to reopening, to corporate transformation, to aging populations, to reshoring and factory automation, to decarbonization.

Among attractive names within the factory automation universe, for example, is a one-stop, flexible manufacturer of automatic control equipment that is a large company in Topix. It adds value via a range of features, such as automation, labor saving, emissions reduction and tech innovation – while being well diversified in terms of production capability, sales network, and R&D capability. At the same time, the company’s strong supply chain has attracted global companies to look to service global operations.

Meanwhile, to capitalize on the growth in aging, COVID saw some companies expand their reach to more overseas hospitals. In the case of one leading medical device manufacturer, this led to an increase and diversification in the revenue base, with its highly-rated bedside monitors helping to reduce the burden and workload of medical staff. Plus, the company has other products that it could cross-sell.

These brief examples reflect why agility is crucial to being able to extract alpha. In short, taking a style-flexible approach – not just investing in large cap names – enables a balanced, and high conviction stance over a medium- to long-term horizon.

Bringing expertise and conviction into focus

Achieving this outcome in a market like Japan with its unique dynamics requires an experienced team on the ground. This is reflected in BlackRock’s US$68bn in AUM in domestic equities across active and index securities, as of mid-2023.

Such scale paves the way for unique access to companies through meetings with top management, helping to create checkpoints to obtain or reaffirm convictions for sustainable growth to fuel long-term outperformance.

Yet despite this large base in Tokyo with its deep ties with local companies, incorporating a global perspective is key to BlackRock’s success in this asset class. As a result, the onshore team is embedded within a global platform of 260-plus fundamental equity investors. The outcome: local research that is sharpened by global insights.

BlackRock’s conviction, which stems from this blend of local expertise with a global platform, enables the team to be nimble enough to take style tilts to respond to the changing market environment. Such style flexibility, which defines BlackRock’s approach, aims to capitalize on an investable universe in Japan of over 2,000 names from various industries with diverse global exposures.

It is also a process that can find attractive valuations, performance, and macro inflection points to inform allocation decisions.

Ultimately, this robust way to generate alpha in Japan offers a longer-term, strategic allocation opportunity.