Japan's Equity Market: Why You Should Invest Now

Japan has long been considered an undervalued and overlooked market, but it is currently undergoing a profound transformation that is making it an attractive investment opportunity. The renewed interest in this market stems from revamped investor sentiment, evolving macroeconomic conditions, and compelling corporate reforms.

Japan's economy and stock market seem to have finally moved on from three decades of battling deflation and economic stagnation. The return of positive policy rates reflects the success of embedding inflation, with recent wage negotiations showing promising signs of a structural shift towards an inflationary environment. This has led to the Bank of Japan's first rate hike since 2007, ending the era of negative interest rates.

Corporate reforms are also driving companies to return capital and strengthen earnings, with more than half of Japanese companies surveyed planning to increase dividends and share buybacks running at roughly 4x the average of the last decade. Foreign institutional investors are also starting to warm to Japanese equities, and in a structurally higher inflationary environment, domestic investors are incentivized to put their huge savings to work.

Japan's market has the largest average daily trading volume in Asia after China's onshore market, and its depth and breadth could attract more significant international funds. The country also offers leading quality companies with global platforms and products, as well as sector-agnostic investment potential.

Additionally, Japan is in a geopolitical sweet spot, benefiting from its position as a 'China alternative' in the midst of tensions between the US and China. Japanese companies are leaders and shapers of their industries and are likely to be in demand from both superpowers.

All these factors contribute to Japan's improved growth trajectory, rising profitability, low valuations, stable political environment, and demographics-driven innovation, making it an attractive prospect for investors looking to diversify their portfolios.

Strong economic recovery

Japan's economic recovery is being powered by consumption and capital spending. A strengthening labour market, with annual wage gains above 5%, a growing percentage of people working or seeking jobs, and record-low unemployment, is reigniting consumer spending. As a result, many Japanese companies are ready to spend on capital projects, with investment spending in 2025 expected to hit its highest levels in the country's history.

Japan's economic recovery is also supported by currency dynamics that are still favourable for exporters. The yen's appreciation has touched off an unwinding of the "yen carry trade", contributing to deep losses in Japan's equity markets. However, a gradually stronger yen is expected, which will make it more attractive for investors to buy international assets that have been oversold in the recent global correction.

The return of positive policy rates reflects success in embedding inflation. Japan's central bank has signalled that more rate rises can be expected, which may further strengthen the yen. A recovery in the US housing market, for example, could boost Japanese companies that own home builders in the US, supply construction materials, or run mortgage refinancing arms.

Japan's economic recovery is also supported by corporate reforms. 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.

Japan's economic recovery is also supported by labour and cultural reforms. To compensate for a shrinking workforce, new policies have brought more immigrants, women, and retirees into the workforce, and the practice of lifetime employment is starting to fade. Beyond government-mandated policies, corporate culture in Japan is also modernising, moving toward a more merit-based system.

Investor-friendly reforms

One of the primary goals of Abenomics, the economic policies implemented by former Prime Minister Shinzo Abe, was to enhance corporate governance. This led to the introduction of Japan's "Stewardship Code," which promotes higher dividend payouts, increased shareholder activism, improved corporate profit margins, and a higher return on equity (ROE) for many Japanese companies.

Additionally, companies are adopting more investor-friendly practices. For instance, more firms are publishing their profitability goals and providing provisions for minority shareholders to demand transparency. Sanctioned avenues for shareholders to remove underperforming management teams are also being introduced.

These reforms have resulted in a more favourable environment for investors, with increased transparency, improved corporate profitability, and a stronger focus on shareholder returns.

Increased capital returns

Japan's equity market is currently experiencing a period of transformation, with a variety of factors contributing to its growth trajectory. One of the key drivers is the increased capital returns to shareholders by Japanese companies. This is evident in the significant number of companies announcing share buy-back programs, with the number exceeding 1,000 in 2023 for the second consecutive year. Share buy-backs enhance the investment potential of Japanese equities by improving the investment quantum for retail investors, making it more affordable for them to participate in the stock market.

Moreover, Japanese companies are increasingly focusing on improving capital efficiency and allocation, which is aligned with the government's initiatives. This includes increasing dividend yields and stock buy-backs, resulting in higher returns for investors. More than half of the companies surveyed by Morgan Stanley plan to increase dividends, which is well above the long-term average. Share buy-backs are also running at approximately four times the average of the last decade. These actions demonstrate a commitment by Japanese companies to enhance shareholder value and improve capital efficiency.

The strong fundamentals of Japanese equities, including healthy earnings profiles, position them well to navigate market volatility and provide resilient growth traits. This is further supported by the country's positive macroeconomic backdrop, with the Bank of Japan's expansionary policy fostering a healthy inflation rate. The return of positive policy rates reflects the success in embedding inflation, which has led to significant wage increases and a move towards an inflationary environment.

Additionally, Japan's equity market offers depth and breadth, making it attractive to international investors. The market has the largest average daily trading volume in Asia, second only to China's onshore market. This liquidity enhances the potential for significant international fund inflows, further contributing to the increased capital returns in the Japanese equity market.

In summary, the combination of corporate reforms, improved capital efficiency, and a positive macroeconomic environment positions Japanese equities for increased capital returns. The market's depth and liquidity, along with the structural reforms, make it an attractive opportunity for investors seeking exposure to a diverse range of industries and low correlations to other asset classes.

Government incentives

Tax-Advantaged Savings Schemes

The Japanese government has introduced a revamped tax-advantaged Nippon Individual Savings Account (NISA) programme to incentivize domestic investors to put their huge savings to work. The new NISA scheme is expected to bring a significant amount of retail funds into the market. The number of new account openings has more than doubled in the six months through June 2024, with account sizes quadrupling over that period.

Investor-Friendly Reforms

The government has also implemented investor-friendly reforms, such as encouraging companies to publish their profitability goals, providing more provisions for minority shareholders to demand transparency, and creating more sanctioned avenues for shareholders to remove underperforming management teams. These reforms are expected to unlock shareholder value and make Japanese stocks more attractive to investors.

Stimulating Domestic Savings in Equity-Linked Investments

The government has embraced programs to stimulate domestic savings in equity-linked investments, driving new flows into Japanese stock markets. One example is the new Nippon Individual Savings Accounts (NISA), a tax-advantaged stock-investment program.

Geopolitical stability

Japan's geopolitical stability is a key factor in its attractiveness to investors. Japan is in a "sweet spot" in the context of the ongoing tensions between the US and China. Japanese companies are leaders and shapers in their industries, and their products will likely be in demand from both countries.

Japan's political stability is also a significant advantage. The country has a reform-minded, pro-growth government and a pro-business, pro-inflation central bank, which together provide a strong impetus for economic growth. Prime Minister Fumio Kishida has continued to prioritise growth and economic reforms, with a focus on greater capital efficiency, better corporate reporting, and more incentives for individual investment.

Japan's stable political environment makes it likely that the current pro-growth policies will remain in place over the coming years. This provides a level of certainty that is often lacking in other markets, making Japan an attractive option for investors seeking to minimise risk.

Additionally, Japan's status as a politically stable country in East Asia makes it an attractive alternative to China for investors. The country's proximity to China and its strong economic ties with the region mean that it can offer many of the benefits of investing in China without the same level of political risk.

Japan's geopolitical stability is, therefore, a crucial factor in its appeal to investors. The country's political and economic stability, combined with its close ties to both the US and China, provide a level of certainty and security that is often lacking in other markets.

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