As the fourth largest economy in the World (having only slipped from third place during the latter part of 2023), it is difficult to ignore Japan when constructing a diverse investment portfolio.
However, Japan has been out of favour with international investors since the end of the 1980s when it suffered from a steep fall in share prices, followed by decades of economic stagnation. We’ll examine the causes of this and the reasons why Japan is now regaining the interest of institutional investors.
The main stock exchange in Japan is the Tokyo Stock Exchange (TSE), which was established in 1878 and as at December 2023 had 3,899 companies listed on it. Some of the biggest and best known of these are
There are 2 main indices that measure the value of Japanese equities.
The most widely used is the Nikkei 225 which measures the largest 225 companies by share price, denominated in the Japanese currency, the yen. This is unusual amongst international stock market indices, which generally include and rank companies based on market capitalisation.
The other major index is the Tokyo Price Index, commonly known as TOPIX. This also tracks the largest companies in Japan, but based on the change in their market capitalization rather than simply share price. It is therefore considered to be more representative of the performance of the Japanese stock market.
The Japanese economy has a diverse range of major companies from automotive and heavy industrial to financial, pharmaceutical and technology. However, in the 1980s an asset and share price bubble inflated prices dramatically. This bubble burst between 1989 and 1991, and prices have taken more than three decades to recover. There followed more than twenty years of deflation and price stagnation. This has become known as Japan’s “lost decades”.
It’s possible that this situation is now reversing, largely as the result of reform in corporate governance in the equity markets and a change in direction by Japan’s central bank, the Bank of Japan.
There were a number of circumstances that led to the asset price bubble that saw stock and land prices triple between 1985 to 1989. Loose regulation and economic policies were the main causes, allowing companies and individuals to borrow at extremely low rates of interest in order to speculate excessively, particularly on real estate.
This was exacerbated by a historic culture where it was normal for companies transacting business together to buy shares in each other as a sign of good faith. As these companies, particularly the largest “blue-chip” corporations, held large amounts of prime real estate, their share prices were highly dependent on the value of that real estate. This large-scale cross investment between companies meant that the change in prices of shares and real-estate was multiplied on the way up but, critically, also on the way down.
Because of lax corporate governance and accounting standards the level of cross investment was not apparent until after the bubble burst.
In 1989, concerned about rapidly rising inflation, the Bank of Japan announced that it was going to start increasing interest rates, which it did over a period of years to 1991. The prospect of rising interest rates had a profound effect not only on Japanese corporations but also on individuals who had borrowed at low interest rates to speculate on real estate, the price of which was already massively over-inflated.
The resulting crash in asset prices saw the main measure of Japanese shares at the time, the Nikkei index, fall from its peak in 1989 by an eye-watering 82% by March 2001. It has taken until the beginning of 2024 for the price of this index to recover to its 1989 high.
A major and realistic fear was that the banks, predominantly domestic, that had lent based on massively over-inflated real estate prices, were at risk of collapse. In fact, Japan suffered a financial crisis that was on a par with that experienced in The Western Hemisphere in 2008, but Japanese banks were propped up by massive cash injections and loans from the government that merely allowed them to survive as “zombie banks” that had no liquidity available to lend to businesses or individuals. Over subsequent years there was a consolidation in banking so that there are now only four major banks in Japan.
The inability of banks to lend, a crippling national debt, and competition from emerging competitors in Asia, notably South Korea and China, led to severe loss of employment security. Long-term price deflation encouraged companies to sit on cash rather than invest in growth, and consumers were likewise reluctant to buy goods or invest, as they could buy the same goods or assets cheaper in the future.
The events of 1989-1991 revealed the extent of the cross investment problem in Japanese corporations, but continued loose regulation failed to unwind the problem until recently.
The Bank of Japan reduced interest rates to zero or less to try to stimulate the economy but, in the face of deflation, companies and individuals chose to consolidate or sit on cash rather than buy assets.
There was also international scepticism about the complicated structure of the Tokyo Stock Exchange which, until the beginning of 2023, had five different groups of listings all with confusing and fairly relaxed listing criteria. This meant that once a company was listed it was easy for it to stay there regardless of underlying value, accounting or governance.
Reforms in corporate governance and accounting requirements were started 10 years ago that included encouraging corporations to unwind their cross-investment and to offer investor value by implementing growth strategies. This has been slow to take effect due to continued deflation and a lack of incentive to reform. However, wage and price inflation has recently begun to rise modestly and The Bank of Japan has recently started to raise interest rates from 0% or less. This could be taken as a sign that decades of government stimulus of the economy is now taking effect.
From the beginning of 2023, there has been a record number of share buy-backs to reduce cross- investment in Japanese companies, as they have begun to see value in investing for future growth and utilising the cash they have been sitting on for decades.
The TSE has been reformed so that there are now only three groups of companies in the listing, divided on the basis of market capitalisation, investor relations and standards of governance and accounting.
Institutional investors are taking a renewed interest in Japanese equities, partly due to the reforms in transparency, but also based on their opinion of value compared with similar equities in other developed markets. Over the 12 months to March 2024 there has been rally in Japanese share prices that has seen the main indices outperform the US and European markets in local currency terms.
Domestic investors are heavily underinvested in equities compared to those in other developed countries, having held cash over the recent decades. However, in the face of still low interest rates and moderate inflation they may start to venture back into equities to achieve real returns, especially given the improved transparency and governance in Japanese corporations.
The combination of interest from foreign and domestic investors may continue to drive the recent change in sentiment towards the Japanese equity market.
There has been recent change in the Japanese equity market. It remains to be seen whether this will be sustained and, as with any investment in equities it is vital to understand the risks before investing.
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