Key Takeaways:

• The macroeconomic backdrop in Japan is improving as moderate inflation and the weak yen are likely to boost consumption and economic growth.

• The Japanese equity market may be poised for upside due to low valuations, lack of ownership and limited research coverage.

• Secular growth and improving corporate governance will drive long-term returns of Japanese stocks.

Japanese equities have been out of favour for decades. Concerns over economic growth and corporate governance have left the asset class under-owned by investors and under-researched by analysts.

Yet average earnings per share (EPS) of the Japanese TOPIX has grown as much as the US S&P 500 in the past decade¹. After solid performance in 2022, we think that Japan could once again be one of the better-performing equity markets in 2023. We uncover the potential drivers of Japanese equity returns.

Equity market 2022 returns and 2023 forecasts in USD

Moderate inflation and a weak currency could boost economic growth

Inflation has been a source of concern for many economies but it’s a different story for Japan. In an economy that has grappled with deflation and low growth for years, some inflation is welcome. Importantly, recent data showed the greatest monthly wage growth since 1997, which could help boost consumer spending and economic growth.

This potential for higher consumption may be coinciding with a wave of pent-up demand; Japan is still in the earlier stages of a post-Covid rebound, having only lifted strict border controls in October 2022. Consumption and travel are still below pre-Covid levels and we expect both to normalise over the course of 2023.

With only modest inflation in Japan, interest rates remain low compared to other regions, where rates have risen sharply. As a result, the yen is one of the cheapest currencies in the developed markets, based on a real effective exchange rate. A weak currency could drive increased sales at Japan’s many export-oriented companies while also attracting inbound tourists. In fact, spending by tourists contributed almost 1% to Japan’s GDP before Covid.

Low valuations, lack of ownership and limited coverage create upside potential for Japanese stocks

A weak yen also provides a discount for foreign investors buying Japanese equities, which are already relatively inexpensive. The Japanese equity market is trading at 12x earnings and 1.1x book value, which is close to the trough and a level from which the market tends to rebound quickly.

The near-term macro drivers and low valuations might also finally get investors to increase their allocations to Japanese stocks. Many portfolio managers remain significantly underweight Japan relative to their benchmarks; any return toward more neutral positioning could provide meaningful technical support.

Portfolio managers remain significantly underweight Japanese equities

While all of these factors could help the broader Japanese equity market, there is a compelling additional opportunity for active managers. Lacklustre performance of Japanese stocks meaningfully reduced research coverage of the equity market over the past couple of decades. Only about 50% of the listed companies in Japan have sell-side coverage at all vs. 99% of the S&P 500². Active managers with well-resourced, local investment teams and experience in the Japanese markets will have the greatest ability to uncover opportunities before the market does.

Secular growth and improving corporate governance will drive long-term returns

We believe many Japanese companies will continue to benefit from several major global secular growth trends, including automation, digitization and online commerce, and renewable energy. Japan is home to some of the leading automation companies, whose technology is in high demand globally in the current environment of wage inflation. However, Japan actually lags many countries in digitization and the shift to online commerce and its efforts to catch up are likely fuel growth for a wide range of companies. As a country highly dependent on importing fossil fuels, Japan has strong incentives to continue developing renewable energy resources, which is becoming an important investment theme.

Improving corporate governance is another global trend that is especially significant in Japan. We believe weaker corporate governance in Japan is the single biggest reason for the persistent discount in Japanese equities. Therefore, the trend of improving corporate governance could be a major driver of returns. Japanese companies have made notable progress returning cash to shareholders: combining dividends and buybacks, Japanese equities were yielding 3.7% toward the end of 2022³.

While the long-term case for investing in the third largest economy in the world remains intact, we think a combination of near-term factors—from an improving macro backdrop to low valuations—could finally convince investors to show Japan some love.