For years, I've watched as international investors turned away from Japan’s stock market, seeing its meager gains reflect the country’s prolonged economic stagnation. But now, Japanese stocks are grabbing everyone's attention, with the Nikkei 225 index hitting a 34-year high. Many people have been asking me whether the Japanese stock market is worth diving into. Personally, I have doubts about the sustainability of this rally amidst its current surge.
The Japan Stock Rally: Explained
The Nikkei 225 surged past the 40,000 mark on Monday, having surpassed its 1989 record high, indicating a significant uptick in market activity. External factors, such as the robust U.S. economy and a notable increase in AI-related companies, have played pivotal roles in driving momentum within Japan's stock market. Particularly noteworthy is the Information Technology sector, which constitutes 24.23% of the index and has significantly contributed to this surge.
Recent corporate governance reforms instigated by the Tokyo Stock Exchange have incentivized Japanese companies to prioritize shareholder returns through mechanisms like share buybacks and increased dividend payouts. Additionally, the weakening yen, presently at its lowest levels since the 1990s, has further amplified corporate profitability and consequently enhanced the attractiveness of Japanese stocks, which were already considered relatively affordable by global standards.
There are also encouraging indications that the Japanese economy may be on the cusp of emerging from its prolonged deflationary phase, as evidenced by notable wage increases experienced by workers last year, marking the most substantial rise since the early 1990s.
Moreover, Japanese stocks have been buoyed by challenges confronting other global markets, particularly China. With China contending with issues like regulatory crackdowns on private industries and sluggish real estate dynamics, foreign investors withdrew a substantial $29 billion from the Chinese stock market in 2023, significantly impacting inward investment trends.
The Headwinds to the Japanese Economy
Japan’s corporate governance reforms have been instrumental in driving the country’s stock markets. However, it's crucial to acknowledge that stock indexes may not provide a comprehensive view of the entire economy, including small and medium-sized enterprises (SMEs) and households.
SMEs play a fundamental role in Japan's economy, contributing 70% of national employment and 50% of economic growth. Despite their significance, there appears to be a disparity between the rally in Japanese stocks and the overall economic health of the country, especially with Japan recently slipping into a technical recession and conceding its position as the world’s third-largest economy to Germany.
There are also concerns regarding the sustainability of the Nikkei's rally. Although solid third-quarter earnings prompted Bank of America to revise their 2024 year-end forecasts for the Nikkei 225 upwards, experts caution against anticipating a continued linear uptrend. Corrections are possible in the coming weeks or months.
The sustainability of foreign profits, heavily influenced by the dollar-yen rate, introduces a layer of uncertainty to the Nikkei's rally. Additionally, Japan's domestic economy remains fragile, lacking vitality and grappling with challenges such as an aging population and stagnant productivity growth.
A strengthening yen could dampen the significant tailwind for earnings, while a potential recovery in China's economy might redirect investments away from Japan, further jeopardizing the Nikkei.
Given recent weak economic data, experts stress that the Nikkei may not accurately reflect the state of the country’s economy. While the index has experienced notable gains, it's imperative to recognize that equity markets serve as sentiment indicators and can be more volatile than the underlying economy. Therefore, the recent rise in the Nikkei may indicate a reduced risk of chronic deflation rather than a significant improvement in Japan’s economic outlook.
Here’s my simple hypothesis: if I have the opportunity to invest in a country with robust stock market momentum and improving fundamentals like India, the US, Vietnam, and technological stocks, why would I consider investing in Japan, where the economy seems to be heading in the opposite direction?
Nevertheless, there’s a possibility that positive animal spirit could reshape domestic consumption and investment patterns in Japan. This could potentially lead Japan into a new golden age after years of stagnation.
Portfolio Performance
Our investment strategy, centered on the US and the technology sector, has delivered significant returns since the beginning of the year. In February, our portfolio showcased robust performance, with a gain of +3.26% for the Cash portfolio, +6.48% for CPF-IS, and +3.08% for SRS. This month, US small-cap stocks have outperformed significantly, even surpassing the stellar performance of tech stocks. Despite these developments, there will be no immediate changes to our portfolio strategy as I expect the market bull run to continue..
Click here for the Fund Factsheet for Feb 2024
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