Globally, moderating core inflation and a solid pace of economic growth have raised market participants’ hopes for a soft landing, but Japan is an idiosyncratic story. The pace of U.S. growth has been above trend, supported by solid consumption; weakness in the global goods cycle continues to weigh on growth momentum in the euro area and China. But Japan’s economy is different – and fresh data increasingly point to reflationary dynamics taking hold after more than 30 years.

Reflation in Japan

Japan’s nominal GDP growth trend has made a notable structural shift upward over the past year, in part reflecting companies’ success in passing on price increases to consumers. Nominal GDP growth accelerated to an annualized 12.0% in Q2 2023, from 9.5% the previous quarter — the strongest uptick since the current GDP series began (1994) and a significant improvement over the 0.4% average pace before COVID (1994–2019).

A recovery trend in wages and, in turn, consumer spending appears to be underway, leading us to believe Japan’s post-reopening recovery still has legs – despite a Q2 2023 GDP report that showed weaker-than-expected real private demand.

Household consumption has yet to fully recover from pandemic lockdowns and remains below pre-pandemic levels. While higher inflation has weighed on real income since early 2022, consumer confidence has improved sharply since the start of the year, helped by rising expectations of higher wages. This year’s spring annual labor wage negotiations resulted in a 2.1% growth in base wages, the fastest in three decades. This improvement, together with a recent hike in the minimum wage, will likely sustain the recovery trend in wages and consumer spending.

We expect fixed investment to trend higher in 2H 2023, given that Japanese firms are experiencing ongoing labor shortages and businesses polled told the Tankan survey they had strong capex intentions. Overall, the strong trend in nominal GDP growth gives corporate earnings a favorable backdrop and should provide support for capex and wages.

As economic slack continues to tighten, price pressures are building in Japan. The key indicator the Bank of Japan (BoJ) uses, core inflation excluding fresh food and energy, has exceeded 4% year-over-year (y/y) in the past few months, mainly driven by services rather than imported goods. Services inflation alone in July reached 2.0% y/y for almost the first time in more than 30 years.

We expect Japan’s inflation to remain elevated due to this broadening of services inflation and gradual disinflation in goods prices. Goods inflation will likely be slow to come down, even as import cost pressures ease, mainly because Japanese corporations are late in passing on their higher costs, which began rising last year. Investors’ focus will continue to be on this dynamic: To what extent can companies in the service sector pass on higher wages in their pricing, leading to a virtuous cycle of rising wages and prices? We expect to see more of this, amid solid consumption demand.

The BoJ adjusted its yield-curve-control (YCC) in July, effectively increasing the 10-year Japanese government bond’s permissible trading ceiling to 1%, from 0.5%. The central bank’s explanation for the change struck a dovish tone (a desire to improve market functionality and reduce market volatility), suggesting it was not yet confident it would achieve its 2% inflation target in a sustainable manner.

In our view, the BoJ has more work to do in normalizing monetary policy, now that as Japan has decidedly emerged from the deflation that first necessitated the ultra-loose monetary policy. However, the hurdle is higher for more substantial policy tightening moves: The BoJ will require further improvement in the underlying inflation outlook. Specifically, the BoJ will need to see more persistent wage improvement, rather than just one good spring wage negotiation. Our base case expects the BoJ to stay on hold for the rest of this year and to exit negative interest rates in 2024.

The macro and market case for Japanese equities

We prefer less expensive cyclical equities markets, at a time when we expect relatively resilient yet sub-trend global growth in the current late-cycle global environment with higher-for-longer interest rates. Japanese equities provide these tilts and stand out as our preferred market within global equities, with what we believe is more growth upside.

Japan was one of the last major market economies to reopen and is a global leader in heavy machinery and auto production, demand for which has continued to stabilize from high levels as supply chains have normalized this year. Reflationary dynamics in the Japanese economy are helping drive nominal economic growth and, in turn, the prospects for top-line corporate revenue growth.

In addition to external demand for goods, a pickup in domestic travel, and an inflow of international tourism after Japan reopened its borders in November 2022, have supported a services sector recovery. A weaker yen has also induced tourist to spend and helped business margins. Foreign tourist arrivals remain below pre-pandemic levels. We believe, however, that with China recently lifting restrictions on group tours, tourism could continue to support Japanese equities.

These developments were at the forefront during the recently concluded earnings reporting season, in which results exceeded expectations. Japanese companies reported strong y/y sales and earnings growth across sectors, and said they had the pricing power to pass on higher costs. Three-month earnings revision ratios are now positive, with momentum suggesting room for further improvement.

Japanese equities have outperformed year-to-date. Higher prices have led to a pickup in valuations and the Japanese market’s average P/E ratio now trades near its long-term average. We believe earnings, and analysts’ expectations, are likely to continue improving, making a compelling case for multiple expansion – and keeping Japanese equities attractive at these price levels.

As more companies’ profits have improved, a larger number have announced that they intend to put aside more money for future capex plans (Exhibit 1). These planned investments may help improve productivity and ultimately help lift margins, especially since corporations can still enjoy low interest rates for financing their plans.

Historically, Japanese companies have maintained high cash positions on their balance sheets. But recent Tokyo Stock Exchange reforms created incentives to improve shareholder returns by better managing the cost of capital. The reforms have spurred a series of restructuring and buyback announcements aimed at improving ROE, further bolstering the case for owning Japanese equities.

Foreign investors haven’t missed these developments and have flocked to the Japanese equity market. But we don’t consider the market overcrowded. Global equity fund positioning still remains slightly underweight Japan, leaving the door open for further inflow that could drive outperformance.

Japanese equities also enjoy low correlation with global markets and might prove a useful hedge in the event of a global market sell-off. They also have a positive correlation with global yields and in an environment of higher-for-longer interest rates, can provide value exposure. Finally, the recent YCC adjustment helps lift the prospects for Japanese financial firms that struggled under ultra-low rates.

We acknowledge that Japanese equities remain vulnerable to a stronger JPY and to volatility caused by the YCC adjustments. However, the yen has weakened since the BoJ’s tweaks in July, and we believe that a gradual strengthening of the currency from these levels will have limited impact on corporate earnings. The BoJ’s dovish stance for the rest of the year will likely also limit headwinds from currency appreciation.

Asset allocation implications

In our multi-asset portfolios, we remain broadly neutral equities and see relative value opportunities in Japanese equities. Reflationary dynamics in the Japanese economy provide a favorable backdrop for corporate earnings, while an increasing focus on efficient capital management by Japanese companies will likely support shareholder returns. Our portfolios maintain a positive stance on duration, which should benefit as inflation continues to cool and central banks approach the end of their hiking cycle. 

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